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 of the money that they are losing. Be careful how you describe your investment success. Be sensitive and generous to those who are losing. Don’t brag about your short-selling triumphs. The social stigma surrounding this style of investing may be the toughest aspect of short selling.

 

Margin Accounts

 

Stock brokerages require that short sellers open a margin account. A margin account allows an investor access to borrowed funds. Since a short sale requires borrowed securities, a short position is by definition margined.

 

The Securities and Exchange Commission has specific regulations covering margin and how it is used. Investors are required to fill out special margin account agreement forms before a margin account can be activated. The agreement is basically a formality, but read it carefully to understand your rights and obligations with respect to using borrowed funds from the brokerage.

 

A margin loan is just like a bank loan. Brokerages charge interest on borrowed funds or securities and that interest must be calculated into the cost of executing a trade. Margin loan rates are generally very low in relation to other consumer loan rates and are usually in the same range as mortgage rates. Margin loan rates vary from brokerage to brokerage. Many brokerages have complex rate structures that vary with loan size, security type, or other factors. Study your broker’s margin policy carefully.

 

A short sale is a credit trade and does not consume any of the investor’s funds. But just like a bank loan, the brokerage will require a specific amount of cash in the account as collateral for a short sale. This is called the margin requirement. The Federal Reserve Board under Regulation T sets margin requirements for all stock brokerages in the US. The federal margin limit is currently set at 50%, meaning that an investor can borrow up to 50% of the funds required to establish a stock position. Brokerages have the discretion to set more restrictive margin requirements, called house requirements, and may exclude certain very volatile or speculative stocks from margin trading altogether.

 

Here is how margin works in a short sale. In this example, an investor places $10,000 in a margin account with a stock brokerage. The account statement looks like this:

 

 

 

With a 50% initial margin requirement, the investor has buying power twice the cash equity in the account. This buying power can be used to buy long or to sell short.

 

If the investor instructs the broker to sell short 500 shares of SGP stock at 40, the account will contain the following positions:

 

 

The short position is now twice the total equity value of the account. This corresponds to the maximum 50% (10,000¸20,000) margin and results in zero additional buying power. This short position represents the maximum short exposure available in this account. The investor can add no further positions to the account, long or short, without providing additional cash.

 

It turned out that this was an astute investment and SGP stock ultimately dropped to 20. The account now has the following values:

 

 

 

The account has now doubled in value with a 50% drop in the price of SGP stock. Notice how the buying power has now increased to $10,000. The reduction in value of XYZ stock has reduced the total margin debt. The investor can now add additional positions, long or short, to the account without depositing additional cash.

The SGP trade was a good investment. Margin can enhance the gains on a good trade. However, margin can magnify the losses in a bad trade. Suppose our investor sold short 500 shares of THC at $40 instead:

 

 

A few months later THC stock drifted upward and the investor continued to hold the position.

 

 

The price of THC rose from $40 to $44. This was not a good trade. In this case the equity in the account dropped to 36% of the total liability (8,000¸22,000) and well below the 50% margin equity requirement. What happens now? Notice that the buying power did not change. This position is still valid because it is within the minimum maintenance margin requirement. The maximum initial margin requirement is 50%, but margin rules allow an existing margined position of 25-35% before action must be taken. Unlike the initial margin requirement, the minimum maintenance requirement is determined by the stock exchanges but brokerages may establish more stringent house requirements.

 

If THC stock rises further and the investor does not cover the short position, then the account value will fall below the maintenance requirement and the investor will receive a margin call. In a margin call situation, the broker will contact the investor and inform him or her that the account is below requirements and action must be taken. Either the investor must add cash to the account or cover the short position at a loss. If the investor refuses to take an action, the broker will close the short position using the investor’s funds at the current market price.

 

The THC trade shows the danger of using the maximum margin. It is very seductive to use the maximum margin power to enter the biggest trading positions and therefore receive the biggest return. This is usually a recipe for a margin call. The first rule of investing is to not lose money. Margin calls almost always result in lost capital.

 

Margin calls are a bad thing. Brokerages may revoke margin privileges to investors who repeatedly trigger margin calls. Investors should protect short positions in order to avoid a margin call situation. This is typically done using automatic stop orders (also known as stop-loss orders). The next section describes the use of stop orders to protect short positions.

 

Make sure that you completely understand your broker’s margin requirements. Different brokers may offer substantially different terms for short sellers. Some stocks may have special margin requirements due to unusual activity or special situations.

Protecting Your Position

 

In any stock trade, there is a risk of loss. In order to control this risk, successful investors enter a trade with predetermined exit points. These exit points correspond to expected profit and tolerable loss. Sooner or later every investor makes losing trades. Losing trades are okay if you make enough on the winners to exceed losses. Win big but lose small. The old adage “Cut your losses and let your profits ride” sums it up pretty well.

 

A short position loses money if the stock rises, so a method is required to close the position if the stock rises beyond a predetermined level. All stock brokerages offer buy-stop orders. These are standing orders to cover a short position if the stock rises beyond a specified level. These orders are usually placed as “good-till-cancelled”, meaning that they are in effect until the investor instructs the broker to cancel the order.

 

For example, if an investor enters a short sale of 100 shares of XYZ stock at 50, a typical stop price would be 55 meaning that the investor will only tolerate a 10% loss in the position. If the stock price rises over 55, the stop order becomes a live market order to purchase 100 shares of XYZ. It is important to understand that a stop order becomes a market order once the stop price has been violated. The stock may gap through the stop price, meaning that it does not trade at all at 55 but at a higher price. Stock price gaps often occur overnight as the result of some news event. For example, if the stock trades at 53 at the end of the previous trading day and opens at 58 in the morning, then the stop order would be executed at 58. The stop order will not guarantee that the position will be covered at exactly 55, but it will be covered.

 

Another type of stop order is the stop-limit order. In the stop-limit order, the order becomes a limit order if the stock violates the stop price. This will guarantee that the order will be placed at the specified price, but will not guarantee that the order will be executed. In the case of the price gap discussed above, a 55 stop-limit order would not have been executed because the stock never traded at that price. Because of this, stop-limit orders are less effective protection than simple stop orders.

 

Create a simple stop-loss policy for all stock trading. Some investors just use a straight percentage such as 8% or 10%. Others set stop orders just above chart resistance areas. Use the policy that makes sense for your investing style and stick to it.

 

The buy-stop order is a core risk management tool for the short seller. Bear market rallies can be sharp and violent. It is important to protect your profits so that you can exploit the higher prices that bear market rallies provide. Manage buy-stop orders carefully to track the action of your portfolio. Many investors use them to automatically exit trades and lock-in profits.

 

As an alternative to buy-stops, some investors use call options to hedge short positions. A call option is a contract that allows an investor to purchase a specified stock (the underlying stock) within a specified time frame at a specified price (the strike price). If the underlying stock rises above the strike price of the call option, then the option may be exercised to purchase the stock at the strike price regardless of the current market price. Call options are sold at a small fraction of the cost of the underlying stock and increase in value dramatically if the underlying stock rises. Options trading is complex and not recommended for casual or inexperienced investors. That said, call options provide very good loss protection on a short position for a specific period of time. This protection has a cost however, which is the premium paid for purchasing the call options. Call option protection can be thought of as term insurance for your short position.

 

Options are sold in contracts representing 100 shares. One contract must be purchased for each 100 shares of stock sold short. Option contracts are sold at specific strike prices and expiration dates. A call option should be selected that has a strike price above the current stock price and with an expiration date that covers the expected holding period of the short position. The strike price will determine the maximum loss level from the short position. A strike price very near the current stock price will cost more than one that is much higher. The higher strikes provide less protection and therefore cost less. Longer-term options cost more also. Buy just as much protection as you need but no more. Options cost money and eat into profits.

 

Should the shorted stock rise, the call option will also rise in price to approximately cancel the losses from the short position. If this happens, the call option should be sold and the short position covered in separate transactions. Do not exercise call options to close a short sale. Exercising an option with time until expiration will waste money because the time value left in the option can be recovered through a sale.

 

The main advantage of the call option is that it can protect a short position against the dreaded gap up. Disadvantages are higher cost for the trade and greater complexity. Call option protection is best used on stocks that have a history of gap trading. A good broker can be of great assistance in setting up a call option hedge for a short position.

 

Protection is best used when establishing a new position. A mature short position on a stock that has fallen dramatically has little risk of turning into a loss and will not contribute much risk to a portfolio. Stocks that fall hard in a bear market usually stay down and most will never recover former heights.

Other Characteristics of Short Selling

 

Short Interest

 

There is only so much stock available in any company. Only a portion of that stock is available for short selling. The total amount of a particular stock that is sold short is called the short interest. Typically, the short interest is only a few percent of the float, which is the total number of shares available for sale to the public. Sometimes a stock may generate enough short selling that short interest becomes a significant percentage of the float. Stocks with high short interest are dangerous to short. They are vulnerable to a short squeeze where the stock moves up sharply and forces many of the short sellers to cover all at once. Short squeeze rallies can happen even if the stock is virtually bankrupt. Short squeeze rallies are violent and swift and can cause huge losses among short sellers. This is the chief danger in short selling. Always investigate the short interest of any stock before making a trade. Large short interest usually accumulates on a stock after a long decline. Often, these stocks make good candidates for going long to capture a gain from a short squeeze.

 

Dividends

 

Some companies issue regular cash dividends to their shareholders (although not nearly as many companies pay dividends today as in years past). All shareholders, including the brokerages that have loaned out stock for short sales, expect these cash dividends. If a dividend-paying stock is sold short, the short-seller will be required to reimburse the brokerage for any dividends paid out during the short position holding period. In most cases, the dividend will be very small and inconsequential. But some stocks pay substantial dividends which may make the trade unprofitable. The brokerage will automatically debit from cash balances for dividend payments. Always note dividend rates and payment dates when analyzing a stock for short sale.

Stock Splits

 

Companies often announce stock splits such as 2-for-1 or 3-for-2. These actions do not materially affect any stock position long or short. An investor that holds 100 shares of a $100 dollar stock that splits 2-for-1 will end up with 200 shares of a $50 stock. For unknown reasons, some investors trade on stock splits. During the 1990’s bull market, stocks often rallied after a split. There was no fundamental reason for this activity but traders had to pay attention to them. Since 2001 however, stock splits have often not resulted in big rallies, they have often preceded declines. This is may be due to a change in institutional investment guidelines. In bull markets, stock splits are often buy events. But in bear markets, stock splits are often sell events.  Stock splits do not have any fundamental meaning, but they may trigger a market reaction.

 

Bankruptcy

 

When an indebted company cannot meet its payment obligations, it must declare bankruptcy. High-debt companies are some of the first to collapse in a downturn and these make some of the best short-sale candidates. The bankruptcy process determines how the assets of the company can be split up between creditors. Taxes, employees, vendors, and lenders have precedence over shareholders in a bankruptcy. In fact, shareholders are the last to be paid. This usually means that there is nothing left for shareholders and the stock goes to zero. Even if the company continues operation under Chapter 11 bankruptcy guidelines, existing shareholders typically get nothing. Bankruptcy of a shorted stock is the best possible outcome because the stock essentially goes to zero for a 100% gain in the trade. Once bankruptcy is declared, the short seller may cover at any time. This gives the short seller some flexibility in tax planning for determining when to declare a profit. Profit in a short sale is booked on the date the position is covered. If you have made a lot of money this year short-selling stocks, it may be tax-efficient to cover the position in the next calendar year to push out profit declaration and tax liability.

 

Entering a Short Position

 

You have opened your margin account, done your analysis, and have identified a great short sale candidate. It’s time to actually make a trade. But there are still some choices to make. A short sale trade can be placed as a market order or as a limit order. A market order instructs the broker to execute the order immediately at the prevailing price. A limit order instructs the broker to only execute the order when the stock trades at a specified price or higher. Typically, a market order will be executed soon after the order is placed. Sometimes however, a short sale market order may be slightly delayed because of the uptick rule (see Appendix). A limit order will guarantee a price but will not guarantee the order is executed.

 

Most short sales should be placed as market orders. This will guarantee that the order will be executed at close to the current price. Use technical analysis to identify strong resistance areas where short sales make the most sense. Short sales are best executed on countertrend rallies. It can be emotionally difficult to buck the trend and trade against rallies but this is the best time to short.

 

Emotions are the biggest danger any investor faces during entry and exit points. All of the best analysis can be quickly forgotten in a moment doubt or euphoria. No book or school can offer a solution to the problems caused by emotional trading. The best investors acknowledge their emotions and keep in touch with their feelings about investments. This is important because a stock trade is best performed at the points of maximum emotion that usually accompany a short-term trend change. The technical analysis tools outlined previously can be a powerful aid in determining these emotional climaxes.

 

Many investors now use on-line brokers. Online brokers have simple order entry screens to guide customers through the short sale process. Many online brokers offer excellent order execution via automated systems but do not give the investor any guidance or special service. Therefore, carefully enter all trades and examine the confirmation pages for errors before executing trades with online brokers. Investors new to short selling may want to use a live broker to assist in the trade. A good broker will be able to offer advice on placing short sales and get a better execution.

Taking Profits

 

Exiting a trade is probably the most difficult decision that investors face. Once a position is taken, there is an emotional connection to the stock. If the position is winning, it is difficult to abandon because the experience was pleasant. If the position is losing, it is difficult to abandon because the investor must face a failed trade. This is why a predetermined exit strategy is so important. There are many valid strategies and many successful styles of investing. Many successful exit strategies use good-till-canceled stop or limit orders. These preset orders make the stock movement generate the exit order. This takes the emotion out of the trade.

 

A well-chosen and executed short sale will offer the investor a lot of leeway with exit strategy. Many stocks will fall long and hard, never to return. If a shorted stock falls from 100 to 10, does it really matter much if it rises back to 15? Is there much more to gain by holding it to 5? In either case, profits on this short sale will be similar. Also, a stock that falls from 100 to 10 is in little danger of rising back to 100 any time soon. An investor holding a large short-sale profit has the discretion of closing the position at a convenient time.

 

The short seller will incur a capital gains tax only when the position is covered. Tax issues should be considered when closing trades. A successful short sale investment will allow the opportunity to manage tax liabilities and offer the ability to defer capital gains recognition.

 

Limitations on Short Selling

 

The Uptick Rule

 

After the stock crash of 1929, short sellers were identified as a contributing factor to the crash. Although this conclusion is debatable, the regulatory authorities instituted the Uptick Rule to limit the ability of short sellers to exacerbate a decline. Each trade on a stock is associated with a price and that price is called a tick. The Uptick Rule simply states that a short sale cannot be executed unless the previous trade on the stock was executed at a lower price.  The uptick rule may make it difficult to execute a short sale during a strong decline. Short sales are best executed during a countertrend rally anyways, so the uptick rule is not a significant encumbrance to successful short selling. The uptick rule will not affect the ability to cover a short position since covering is identical to purchasing a stock.

 

“No Shares Available”

 

Occasionally an investor will attempt to sell short a stock but the brokerage will not have any shares available to sell. This may be for any number of reasons. Smaller brokerages will not have an extensive inventory to offer the short seller. Otherwise, there may already be a huge short position in the stock and short sellers have depleted the available inventory.

 

Thinly traded stocks or low-priced stocks under $5 are usually not available for short sale. This is a good thing. Thinly traded stocks have little liquidity and are dangerous for investors long or short. Low priced stocks don’t have as much downside so are less appealing short sale candidates as high-priced issues. Some stocks are not marginable because of various reasons. If the stock is not marginable it usually cannot be sold short.

 

If the broker reports that there are no shares available of a particular stock to short, it is best to abandon that particular stock and look for another candidate. There is usually no lack of good short opportunities in a bear market.

 

Retirement Accounts

 

Short selling is prohibited in IRA and other qualified retirement accounts. However, there are mutual funds that specialize in short selling on behalf of their shareholders. These funds are allowed in retirement accounts and are good tools for investors to exploit general bear markets. Bear funds are usually tied to an index or are diversified in other ways. Because of this, they are not good tools to play a single bearish sector. Another disadvantage of bear funds is that they can only be traded at the end of day. Bear markets move swiftly and mutual funds are a blunt tool to exploit them. However, bear funds may be the only way to profit from a bear market within a retirement account.

 

IPO’s

 

New stocks trading on the market are called Initial Public Offerings or IPO’s. IPO stocks have a mixed reputation for performance. During the 1990’s IPOs were some of the hottest stocks around. Many new issues rocketed hundreds of percent in a few days from the offer price. Since the bear market started in 2000 however, IPOs have had a poor record. In fact many IPOs issued since 2000 have been some of the worst performing stocks. It is tempting to look at these as good short candidates but US securities laws prevent short selling of an IPO for the first six months of trading. This restriction is called the lockup regulation. IPOs in general are not good investment candidates, long or short, because there is too little trading history to provide a proper technical or fundamental analysis. It is best to just stay away from new issues.

 

 

George J. Paulos

Alternatives for Financial Freedom

http://www.freebuck.com

 

Copyright 2003 George J. Paulos, All rights reserved.