8/21:TheStreetCom:" What Happens When Short-Selling Goes Bad "!!!!!
Personal Finance : Dear Dagen
thestreet.com
Squeeze Play:
What Happens When Short-Selling Goes Bad
By Dagen McDowell
Senior Writer
8/21/00 12:03 PM ET
To many investors, short-sellers are evil.
They try to profit from falling stock prices, preying on companies and making stocks fall even further.
That's one opinion.
But short-sellers can also cause a stock to rise
if they're forced en masse to buy back the shares they sold short.
Meet what's called the short squeeze.
In a short sale, an investor borrows stock from a broker and sells those shares
into the market with the understanding that the shares must be bought back
at a future date and returned to the broker.
If the stock falls, the investor buys back the stock at a cheaper price,
making money on the trade. If the stock rises, the investor has two choices:
Wait for the stock to come back down, leaving the short-seller exposed to potentially greater losses,
or buy it back and realize a loss.
Of course, some people will short a stock for other reasons
-- to hedge or offset a long position, for instance. (The various reasons for shorting
were covered in a recent column on short interest, which represents the total number of
shares that have been sold short and not yet repurchased.)
However, the shorts who are trying to make money on a stock's falling price
often get accused of unsavory tactics aimed at pushing a stock lower.
Look at Conseco's (CNC:NYSE - news) current campaign
against the short-sellers who are betting that the
insurance company's stock will continue to fall.
The company has publicly said it thinks short-sellers
and others have been spreading false information about the company's debt financing.
Meanwhile, Conseco shareholder Irwin Jacobs is taking on
the shorts in advertisements urging other stockholders to
forbid brokers from lending their shares to the shorts.
Short-sellers can indeed have a negative impact on a
stock.
Some short-sellers do disseminate negative information
about companies over the Internet or elsewhere.
Just read the message boards out there.
But others are just trying to do what every investor
wants to do: make money.
They just take the mantra, buy low and sell high,
and reverse it, sell high and buy low.
A rising amount of short interest in a stock can send the
message to other investors that some people think a stock
is overvalued or that something is wrong with the
company.
"It's almost a self-fulfilling prophecy,"
says one fund manager. Investors who are long a stock as
well as potential buyers get nervous when they see the
shorts going after a stock. These tacit admonitions can
push shareholders to sell and dissuade other investors
from buying, sending a stock's price lower.
If the price of a stock that's heavily shorted starts to
rise, you can see the opposite happen.
Numerous short-sellers can be forced to start buying
shares to cover their positions, which can drive the stock
price higher and higher.
A couple of events can cause this so-called short squeeze.
When you short a stock, you have to borrow shares from
someone who actually owns them.
A brokerage firm acts as the middleman in the exchange,
but ultimately the shares must be returned to the
rightful owner.
When the stockholder wants those shares back,
the short-seller might be forced to go into the market
and buy them in order to return them to their owner.
In many cases, the brokerage firm, as the intermediary,
will be able to find more shares to loan the short-seller,
who won't have to repurchase the shares.
But if a stock is hard to borrow, such as a new or thinly
traded issue, the short-seller might be forced to go into
the market and buy those shares. (If the short is
dillydallying, the broker can buy the shares directly to
return to the shareholder and pass on the cost to the
short-seller.)
More buying creates additional demand for the stock,
which can cause its price to go higher.
Conseco shareholder Irwin Jacobs is pushing
for just this sort of squeeze.
Jacobs, a corporate raider from the fabulous '80s, has
been urging Conseco stockholders to prevent their brokers
from lending their stock to the short-sellers.
If Conseco shareholders demanded their shares back en masse,
the people who are short the stock could be forced
to buy it in mass quantities.
That buying would probably help this stock, which has
fallen 25% since the end of June.
A short squeeze can also happen when a heavily shorted
stock starts to rise, and short-sellers start buying to
close their positions and cut their losses.
The higher the price goes, the more money the short loses.
At some point, the short-seller will probably give in and buy.
"We get nervous when we are down 30%," says the fund
manager.
Buying begets buying, creating a snowball effect.
Short-sellers buying shares to cover their positions push
the price higher and force more shorts to do the same.
The potential for a short squeeze is one reason that some
investors watch rising short interest.
When a stock's short interest exceeds 20% of the
number of shares that trade, some people believe the stock
is ripe for a short squeeze, which means a nice pop in price.
Alas, these price jumps are usually short-lived.
Once the short-sellers finish their buying, the stock
should return to where it was.
The satellite-telephone venture Iridium filed for
bankruptcy last August, but the shares of its publicly
traded entity, Iridium World Communications, unexpectedly
jumped a few months later thanks to a short squeeze.
That run-up provided some investors with a nice short-term
pop, but it didn't bring the company or the stock back to
life: Iridium in March announced it would shut down.
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Dear Dagen aims to provide general fund information.
Under no circumstances does the information in this column represent a
recommendation to buy or sell funds or other securities.
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