Short sellers, as the market knows them, look for the best stock to sell. Short sellers sell stock they don’t own with the belief it will fall in price in the near future. When the price drops, they can buy the stock at the lower price and pocket the profit.
Selling Short
Here’s how short selling works. Say you believe that the market has way overpriced Amalgamated Kumquats and it is due for a big fall. You call your broker and say you want to “short” 300 shares of Amalgamated Kumquats. Your broker will require you to have a margin account meaning you must meet their credit and deposit requirements. Your broker will then sell 300 shares of Amalgamated Kumquats out of their inventory or “borrow” the shares from another customer or another broker. From 1937-2007, short sales could only be done on an “uptick,” meaning the short sale must be done at a higher price than the last trade. The idea was to prevent a bunch of short sellers from jumping on a declining stock and driving the stock price down further. Whether the uptick rule was effective or not is debatable. In 2007, the SEC eliminated the uptick rule, and shorting could be done at any time. After the financial crisis, some pointed to unhindered short selling of stock as a partial cause of the crisis, but the case for that was not clear. Thus, rather than reinstate the uptick rule, in 2010 the SEC created an alternative uptick rule, where the uptick rule is imposed on the day a stock drops more than 10% from the prior close, and the day after that. Your broker escrows the money from the sale in your account for the protection of the original owner of the shares. You might not earn interest on this money, and if the stock pays a dividend during this time, you’ll owe it to the owner.
How It Works
If the stock falls the way you predicted, you can buy 300 shares at the lower price and replace the borrowed shares. The difference between what you sold the stock for and what you bought it for is your profit. For example: You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold. Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 - $10,500 = $3,000). For being right, you pocket a $3,000 profit in a very short time. However, what happens if you are wrong? This is the dark side of short selling. Same shorting scenario: You short 300 shares at $45 for $13,500. However, instead of falling like reason and logic suggests, before you know it, the stock rises to $55 per share. You decide to cut your losses and cover the short by buying the stock at $55 per share for $16,500. Because of margin requirements, your account has enough assets to cover the $3000 loss, though you might have to liquidate some of the assets to avoid owning stocks using margin. If the rise in the stock price had been considerably worse, where the net liquidation value of your account falls below your broker’s margin rules, you would have had to deposit more money or cover the short by buying the stock. If not, the broker will buy in the stock for you to protect themselves against losses that would occur if your account went negative and you declared bankruptcy.
What Are the Risks?
As you can see, short selling can offer quick profits, but also high risks. The advantage of using someone else’s stock to earn money carries the opportunity for extraordinary profits and the possibility of financial disaster. Here are some of the risks:
You don’t fully control a short sale. Under adverse conditions, where the stock price rises dramatically, the broker can force you to put up more money, or forcibly buy in the stock without your consent. If the price rises, you can lose money. If it weren’t for the broker’s margin desk, losses would potentially be unlimited. If a large number of short sellers try to cover their positions in a stock, it can drive up the price even faster. This is a short squeeze. Short squeezes can also take place if those that own stock move it from their margin account to their cash account, reducing the stock available to borrow, and possibly forcing brokers to buy in the shares that have been shorted at the expense of account holders. If a stock is hard to borrow, those shorting may have to pay interest to borrow the stock, in addition to any dividends the stock pays. Capital gains and losses from shorting are all short-term, excluding short sales that are “constructive sales” of long positions already held. That means your tax rate will be higher than it would be on long-term gains. You are betting against the market’s history, which has trended up. That’s certainly not true of individual stocks; however, a strong bull market may raise the prices of marginal stocks. There is no way to accurately predict when a stock will fall (or rise for that matter). The value the market places on a stock does not always match its metrics. Add to that mix the question of timing and it becomes problematic to predict when a stock will fall. Long-term investors can wait for a stock to rise. A short seller doesn’t usually have that luxury.
How to Pick Shorts
How do you pick stocks to short? It’s easier to tell you what not to do:
Absurd valuation is not a sufficient reason to short. Jim Cramer has said something like, “An absurd price is like infinity. Twice infinity is still infinity. Double an absurd price is still absurd.” As Keynes reportedly said, “The market can remain irrational longer than you can remain solvent.” Don’t short into strong upward price movements. Wait for momentum to fail. Don’t short to zero, even if it is possible. Also, if a stock is delisted, it may become very hard to cover your short position. Avoid crowded shorts that many talk about. Aside from it being hard to borrow stock, these are the situations most likely to have a short squeeze.
Signs that a company might be worthy of shorting include egotistical management teams, weak accounting, weak balance sheets, fads that may be ending, etc. Be sure you have an insight that is better than all of the professionals who own the shares. That is a tall order.
The Bottom Line
Short selling is not for new investors. In fact, many would suggest it is speculating, not investing. Don’t get drawn to the possibility of easy money, because it’s usually not there. The potential for loss is greater than the potential for success. Finally, remember the old couplet about short selling: “He who sells what isn’t his’n, must buy it back or go to prison.”
