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To: Glenn D. Rudolph who wrote (139398)	2/16/2002 5:20:24 PM
From: H James Morris	Read Replies (1) \| Respond to of 164684

Author: Daryl Guppy Date: February, 2002 Publication: Shares (subscribe) When market conditions turn, some people think about selling short the market – that is, selling high and buying lower. The aim is to profit from a fall in prices. It is the flipside of standard long-side trading – buying low and selling higher. Short selling comes in two forms. First is short selling equities or stocks. The second uses a "put" derivative, such as a warrant, an option or a futures contract. We focus on the equity side of the process. Some believe short selling is easy but it carries unexpected risks that make it suitable only for those who are well-capitalised and have well-developed trading skills. Even then it is hard to find a broker that offers these services. How it works Short selling is the reverse of the normal long-side trading where we buy a stock at 50 cents because we believe it is going to rise to $1. We stand to collect 50 cents in this trade. Traders who short sell believe that the target stock that is trading at $1 today will be trading at 50 cents next week. To make a profit from this belief, the trader must borrow the target stock from a broker so he can SELL the borrowed stock at $1 today. Next week he will BUY the stock from another trader in the market at 50 cents. He collects 50 cents from the trade - sold at $1 and bought at 50 cents. He then returns the borrowed target stock to its original owner. Risks Short selling inevitably carries extra financial and execution risk. Recognise, first, that this is a trading strategy. Even those who use this approach as a way of managing risk on a long-term investment portfolio use trading techniques and methods. Short selling lies squarely in the realm of the trader because borrowing stock makes good risk control, excellent discipline, and fast reactions even more significant. The ASX determines which stocks can be sold short based on capitalisation and liquidity. Its Approved Securities list contains around 200 companies. The list, which changes regularly with approved securities added and deleted, is available from brokers, or direct from the ASX as an Appendix to Rule 2.11 - Short Selling. A short sale cannot be made if it would have the effect of causing more than 10 per cent of the number of shares on issue to be sold short. Short sales cannot be made at a price lower than the last price in the market. This prevents short sellers from driving the market down and is similar to the US market's "up tick" rule. The short seller must inform his broker in advance that this is a short-sell order. The broker must ensure the stock is on the approved list and that the order is within the 10 per cent limit. Short sales are flagged to the market and noted on the contract note. Before trading short you have to read and sign a risk-disclosure document. All brokerages have the ability to offer short-selling facilities, though only a handful make this service available, and then often only on a case-by-case basis to a few clients. For practical purposes, short trading is not available to most small traders. Financial risks Trading from the long side gives us unlimited choice of position size. We can spend as little as $1000 or as much as $100,000 or more depending on our judgment of the trading or investment opportunity and the amount of capital we can raise. This does not apply to short selling. Most brokers we contacted set the short selling trade size at a minimum of $20,000, while others set it at $50,000 or more. This immediately suggests that short selling is for professional and skilled participants and not for mums and dads following a whim. There is a sound reason for this. When we trade from the long side the risk is limited and the reward, theoretically, is unlimited. Stocks rarely fall to zero but they can potentially go to $100 or $1000. In short, selling the reward is limited to 100 per cent as a stock price can only fall as low as $0.001. The risk is unlimited as prices may rise without limit. The most obvious risk in every short trade is that the price of the stock will rise rather than fall. The risk of an adverse price movement is standard in all trading and there are well-established methods of dealing with this. Most times when we buy stock we expect it to go up because we are trading from the long side. If it doesn't go up then good traders sell the stock and take a small loss. Many traders and investors have trouble selling a losing stock quickly and their portfolios are studded with long-term failures. This is not good, but it is not fatal because most times the trader fully owns the stock. It costs him money to buy, but it does not cost him money to keep. A failed short sell trade costs money to keep. Execution risks The short trader faces a much more difficult situation because he or she must borrow stock to short sell. The first hurdle is the need to pay the lender a margin to cover the loan. The ASX rules set a minimum of 20 per cent of the value of the short sale. Some brokers will ask for a 30 per cent margin or more. This margin is lodged before the short sale is placed. It can be in cash, or securities. Where other shares are used they are assessed usually at no more than 90 per cent of their current market value. The agreed margin must be maintained at all times and it is calculated on the closing price of the borrowed stock. If the closing price increases by 10 per cent then the trader will be required to meet a margin call. This means providing more capital, or shares. Some brokers require this by 2pm the next trading day and reserve the right to close the short trade at the client's expense if the margin call is not met. The broker has the right to ask for a complete coverage of the open short trade at any time. The second level of additional risk is time. Generally stock is lent only for a specified period. It must be returned by an agreed date and the broker reserves the right to close the trade at the client's expense if this condition is not met. This is an arbitrary period selected by the lender without any reference to the activity of the market. This may not sound a significant risk but it has a big practical impact. Take an objective look at your current long-side trading. How many trades are successful within 12 weeks of entry? When you own the stock it doesn't matter. When you borrow the stock and must return it, the time span does matter. There is reduced room for error. You do not have time to wait for the trade to become successful. Your trading analysis must be correct almost immediately from the time you enter the trade. If you cannot do this when trading from the long side then it is not realistic to expect that you will be able to do it from the short side. Dividends become an unexpected risk. For the long-side trader, the dividend is a bonus. For short sellers it is a penalty like an own goal. The short seller is required to reimburse the stock lender for every cent of dividend and for any franking benefits. The final execution risk is contained in three delete clauses. The first is when a stock is suspended. Luckily this doesn't happen too often, but as HIH Insurance and Harris Scarfe have shown, it is not a risk that can be ignored with impunity just because the stock is considered to be respectable. The list of approved securities changes regularly, and this is the second delete risk. When a stock is deleted from the list of ASX-approved securities, or from the broker's list of approved securities, then all open short trades must be closed. The ability to make a judgment about the trade, or manage it effectively, is taken away by the broker's demand for settlement. The key to trading profits lies in the ability of the trader to manage trading risk. When a third party has power to change this without notice then the traders risk management skills are attacked. The broker acts as an agent, matching borrower with lender. This is the third deletion risk. Because we are dealing with borrowed stock the original lender may, at any time, recall. If this happens, your short-selling position is closed by the broker unless he can arrange for another lender to lend stock. The delete clauses are not invoked frequently, but they are always there and add new risks not found in long-side trading. Short or long? Traders who are successful trading from the long side already have the skills and discipline required to trade successfully from the short side. The reluctance of many brokers to offer these services widely to clients is not evidence of conspiracy or conservatism. It is recognition of the extra risk involved. The novice trader has little real prospect of success in trading the short side of the market using ordinary stocks. When you do find a broker that offers short-trading facilities then there is no guarantee that you will be accepted for short trading. This remains at the broker's discretion. Copyright 2001© Terms & Conditions