Freebuck.com Investing Mini-Course:

Short Selling – Profit From a Stock Decline

 

 

Purchasing a stock is called going long in the jargon of the investment industry. In a long trade, an investor purchases a stock then sells it, hopefully for a profit. A short sale is the inverse of the long position. The stock is sold first then bought back, hopefully at a lower price and therefore a profit. In other words sell high, buy low. How can an investor sell a stock that he or she does not own? Investment brokerages always carry an inventory of stocks as part of their assets. Brokerages are allowed to lend stock to short sellers who then sell the stock into the markets with the understanding that the stock will be purchased back and returned to the lender at some time in the future. The ability to sell a stock short allows the investor to profit from a decline in stock price.

 

The terms “long position” and “short position” are unfortunate because they are not the same as “long-term” and “short-term” investing. The term “short sale” has nothing to do with the length of time the position is held.  A short position can be held for an arbitrarily long period of time. Conversely a “long position” can be held for an arbitrarily short period of time. Be aware of this confusing terminology and be on the watch for improper usage.

 

The short sale technique is not difficult but is a bit more sophisticated than the traditional stock purchase. If, for example, an investor purchases a stock for $10 and sells it at $100, this would produce a $90 profit. A short sale of a stock at $100 that was closed at $10 would produce the same $90 profit. The trick in short selling is to identify good opportunities for significant stock declines. Short selling is a strategy that is best used within the context of a bear market. If most stocks are going down, then the likelihood for a profitable short sale is high. A short sale in the context of a bull market where most stocks are going up makes profit much less likely. Within bull markets, most investments should be long. In bear markets, most investments should be short.

 

Short positions are inherently riskier than long positions. This is because a long position has a limited loss potential (a stock can only go to zero) but unlimited gain potential since there is no absolute limit to how high a stock can go. A short position has a limited gain potential (a fully leveraged short sale has a maximum profit potential of 200%) and an unlimited loss potential. This makes risk control an essential component of a successful short selling strategy. Short selling is a very useful tool for exploiting bear markets but also can be used as a hedging tool to minimize risk against a long position in a bull market.

 How a Short Sale Works

 

A hypothetical investor places $10,000 into a brokerage account and receives a statement from the brokerage that looks like this:

 

 

The investor performs a stock analysis and identifies QCOM stock as a good short candidate by analyzing the technical condition of the chart and the fundamentals of the market:

 

 

The investor then instructs the broker to sell short 100 shares of QCOM at $66.The investment account now looks like this:

 

 

Notice that the investor’s cash position has increased by $6600. This is the money received from selling the stock. The short position is logged as a debt, offsetting the increase in cash so that the total account value remains at $10,000. Short positions are debts and are subtracted from the account’s total equity. As the stock declines, the negative value of the short position also declines resulting in an increase in account value.

 

To illustrate this, let’s follow QCOM stock as it declines to $46. Then the investment account will look like this:

 

 

The decline in QCOM stock reduced the debt for the short position, resulting in an increase of the total portfolio value to $12,000.

 

If the investor decides to close the position at this time, the broker would be instructed to cover (buy back) the short position in QCOM stock by buying 100 shares on the open market for $46. After the order is executed, the account looks like this:

 

 

Purchasing 100 shares of QCOM stock at $46 required $4600 from cash. This left $12,000 cash in the account resulting in a total profit of $2000 for the trade.

 

Of course, if QCOM stock rises, the short position will lose value. The risk in a short position is that it loses money when the stock rises. In this way the short position works exactly opposite to the direction of the stock.

 

For example, if we shorted 100 shares of QCOM at $40 and it rose to $60, the total account value would decline to $8000.

 

 

 

In this way, a short position moves in the opposite direction to the stock movement.

For another example we will look at EMC stock, an extraordinary short sale case study:

 

 

The chart above of EMC in Feb 2001 shows a strong countertrend rally and failure to penetrate the moving average. This is a classic setup for a short sale. Let’s enter a short position at of 100 shares EMC@ 70 and follow it through the stages of this stock’s massive decline.

 

 

Two months later in April 2001 EMC had fallen to $30, a staggering decline. This raised the value of the short account to $14,000.

 

 

Many stunned investors considered EMC a screaming buy at $30 so a rally quickly followed. This bear market rally in EMC stalled at $40. This looks like another setup for further decline, so we decide to sell short an additional 100 shares of EMC @40.

 

The rally did not hold and EMC fell back down to $30.

 

 

By the beginning of 2002, EMC stock had fallen even further to 13 and the short account rose in value to $18,400 for an unrealized gain of $8,400 over less than one year.

 

 

 

EMC stock kept dropping and ended up below $5 during 2002. Our EMC short sales during that period of time would have doubled the value of this hypothetical account. Declines of this magnitude are not uncommon in long-term bear markets. Many stocks have fared even worse than EMC. The examples above show how short selling can exploit these stock declines for profit.

 

Short positions exhibit a different risk profile than long positions. The maximum gain on a short sale is achieved if the stock goes to zero. The loss potential is unlimited if an investor allows a shorted stock to rise without covering. Therefore a short position has limited gain but unlimited loss potential. A long position has unlimited gain potential but risk of loss is limited only to the amount invested. This leads many investors to believe that short selling is inherently riskier than going long. Short selling is indeed very risky when practiced during a raging bull market, but going long can be devastating during a vicious bear market. Stocks tend to fall faster than they rise. Many investors have made fortunes selling short in bear markets. Carefully executed short sales with stop-loss protection in a bear market context carries risk, but being long may be riskier in a vicious bear market.

 

Short selling provides a powerful tool to the investor. With short selling, the investor can profit from stock declines and turn a difficult bear market into an extraordinary opportunity. Long-term studies of the markets have shown that stock markets rise about 2/3 of the time. This means that 1/3 of the time stock markets decline in so-called secular bear markets. During these secular bear markets, it is pointless to be long stocks because very few will show a profit and it is unlikely that most investors will be smart or lucky enough to hold those few. Bear markets are usually shorter than bull markets and move much more rapidly. Stocks fall faster than they rise because fear is a much greater motivator than greed. Short selling can provide extraordinary profits for nimble investors who seize the appropriate short opportunities.

 

Is Short Selling Ethical?

 

For many people, short selling sounds somewhat ghoulish, kind of like dancing on the bones of dying stocks. Some have even called it unpatriotic. It is true that short sellers profit from the woes of unlucky or mismanaged companies. It is also true that profits from a short sale come from the losses of other investors. Short selling is a zero sum game. This leads many people to believe that short selling is unethical or at least sleazy and exploitive.

 

The truth is that most stock investing in secondary markets is a zero-sum game. A company typically issues stock in an Initial Public Offering (IPO) to raise funds for expansion. An IPO is true investment because the funds are being used to finance plant and equipment to run a productive enterprise. From that point on however, the stock trades on an exchange, which is also known as a secondary market. Secondary markets are where investors trade securities with each other. This company that issued the stock will not directly gain from the trade of previously issued stock. (Although a high stock price can certainly help a company in other ways.) When an investor purchases a stock on an exchange, it is purchased from another investor who also purchased the stock on an exchange. Capital gains from the sale of a stock come from the higher price that the next buyer is willing to pay. The only true non-zero sum gains in stock investing come from either dividends or buyout where another firm purchases the shares and retires them from trading.

 

Since few stocks deliver dividends or get bought out, most stock is traded solely for the purpose of capital gains. These capital gains come at the expense of other investors. Maybe not today, but sometime in the future some hapless investor will lose the money that you just made on a stock trade. So what is different about short selling? Nothing really. Profit derived from short selling is acquired at the expense of other investors, just like selling a long position.

 

Short selling is an essential component to healthy markets. Short sellers add additional liquidity to markets and help stabilize them. Short sellers covering their positions can actually stop a stock from falling precipitously. If there is a substantial short position in a stock that is falling, short sellers will be purchasing the stock to close positions. In some cases, short sellers may be the only buyers. This moderates declines. Short sellers can also cause sharp rallies known as short squeezes. This can happen when good news comes out about a heavily shorted stock causing the short sellers to cover all at once. This is why a large short interest in a stock can be considered a supportive indicator.

 

Informed stock investors know that short selling is neither good nor evil. It is just another tool to profit from market fluctuations. Successful investing demands that profits be extracted during both good markets and bad. Nobody can make money being long a stock that is declining. If most stocks are declining, being long any stock is a risky position. It is self-defeating to hold losing stock positions based on false ethics. It is not patriotic to lose money by holding declining stocks. Don’t be a victim! Use all of the investment tools available to defend and enhance your wealth.

Bear Market Etiquette

 

Regardless of market conditions, most investors are overwhelmingly long. Few ever trade short. Short selling is truly the road less traveled. Cocktail conversations about stocks are typically brag sessions about being long a stock that went to the moon. When was the last time you heard someone brag about a spectacular short sale? The next time you are at a party, try telling your best short-sale story and see what kind of reaction you get. Hopefully, your friends will be polite.

 

Even though there is nothing illegal or unethical about short selling, it is still regarded in popular culture as a rogue practice. Many people consider it unpatriotic to sell short the country’s finest firms and profit from their troubles. Short sellers have always created resentment, particularly during bear markets when the majority of investors have lost large sums of money.

 

Stock investing is fundamentally an optimistic pursuit. Most people have a natural tendency to be optimistic. Short selling goes contrary to that natural tendency. This may be why short sellers are mistrusted. Short sellers are not necessarily pessimistic, they are just identifying a trend and profiting from it.

 

One of the most famous short sellers on Wall Street was Jesse Livermore who emerged from the 1929 crash with almost $100 million. Jesse certainly caused a lot of resentment among all of the ordinary people who had lost fortunes in the crash. Some even blamed Jesse and other short sellers for the crash. In response to investor outrage, the stock exchanges enacted rules to limit short selling that remain to this day. After the crash, Livermore often received personal threats and was forced to hire bodyguards. Sadly, Jesse lost his entire fortune in a mistimed investment strategy a few years later and eventually committed suicide. The tragic story of Jesse Livermore has become a parable for the “evils” of short selling.

 

Other well-known bears have been teased and ridiculed during bull markets, then shunned and reviled when their bearish predictions came true. Bearish analyst Jim Grant endured years of ribbing by Louis Ruckeyser on the Wall $treet Week television show during the long bull market. The same Mr. Ruckeyser fired “permabear” analyst Gail Dudack just months before the stock market peak in April 2000. The unfortunate Ms. Dudack disappeared into obscurity just as her bearish forecasts proved correct. Professional stock analysts know that a bearish outlook may permanently ruin a promising career. This may be why bullish analysts vastly outnumber bearish ones. There is little room on Wall Street for a bear.

 

Stock market bears are always in a battle with a perpetually bullish “Wall Street Industrial Complex”. These institutions are designed to sell securities to the public so they are always promoting stocks as safe and sound places to invest capital. Trading commissions by short sellers generate little revenue for the brokerage industry. In fact trading commissions in general are only a small part of investment industry profits. Management fees, investment banking, research, media, and a plethora of related activities make up the big money the investment industry. These institutions need a constant inflow of new capital to survive. Only a continuously bullish marketing message can lure investors to buy these products and services.

 

This bullish message is reinforced by the financial media who receive the bulk of their advertising revenue from the same industry that is after your investment dollars. They have created 24-hour “news” channels that are really nothing more than non-stop infomercials for stock investing. Most people get their financial information exclusively from these tainted sources. Financial media influence is powerful and pervasive. Most common investors simply reflect the bullish perspective of the information they receive from the media.

 

It is not the purpose of this section to discourage purchasing stocks. Quite the contrary. Stock investing is an essential part of a healthy economy. But there is a time to buy and a time to sell. The media will tell you that anytime is the right time to buy but will never tell you when to sell. Successful investors listen to the message of the markets, not the talking heads on the cable news network. The financial media will give no comfort or assistance to short sellers or any other species of the bear family. Short sellers must think independently and not be influenced by the media-controlled stock market pop culture.

 

It is important to remember that other investors may resent all of the money you have made selling their favorite stocks short. You are on the other side of most investor’s trades and making all o