Short Selling Explained A short history of the bear - a brief history of short selling by Edward Chancellor
The benefits of short selling - Fortune article by Herb Greenberg
What is short selling?
Typically an investor buys a stock in hopes it will appreciate. He tries to "buy low and sell high." But if you believe the price of a stock will decline you can sell a stock short. Here, the goal is to sell "high" and buy the stock back "low."
An investor may short a stock because he believes it is overvalued or because there is fundamental problem with the company. Or an investor may want to protect against a broad market decline by shorting a number of stocks or an index.
How do you sell a stock short?
When you short a stock you borrow the stock from you broker and sell it in the market hoping to buy at back later at a lower price. Here's how it works:
Assume you think XYZ stock will decline in price. You short 100 shares trading at $100 a share. You borrow those shares from your broker who then sells them at the going price and deposits the $10,000 from the sale in your account. Now you owe the broker 100 shares of XYZ regardless of the price of the stock. Now assume the price of XYZ falls to $50. You buy the 100 shares in the market for $5,000 and return the shares to your broker. That leaves you with a profit of $5,000 excluding commissions. If you bought back the stock at a higher price, say $150, you would return the shares to your broker, but you would have lost $5,000:
What is a put option?
A put option is the right to sell a stock at a certain price sometime in the future. An investor who buys a put option pays a price (or premium) for that right with the expectation the stock price will decline.
How does a put option work?
Say an investor thinks XYZ Corp., now trading at $50, will fall in price. Let's assume the investor buys a put option in the open market for $2 that lets the investor sell the stock at $50 anytime over the next 90 days. If the stock falls to $40 within that 90 day period, the option would be worth at least $10.*
So why buy puts instead of shorting stock?
In the above example, the investor would have made $10, or a 20% return, by shorting the stock (Sell at $50, buy back at $40.). The option investor would have made at least $8 (buy at $2, sell at $10), a return of four times the investment.
What happens if the stock price goes up?
The value of the option will decline, and will eventually be worthless if not sold before expiration.
*If the option was selling for only $4, for example, an investor could buy the stock for $40, then buy the put option, and immediately "exercise" the option by selling the stock for $50, making a risk free $6.
Can short selling 'take down the market'?
No. First, from a trading perspective, the uptick rule prevents shorting a falling stock. For example, if a stock's last trade was $30 and you want to short 100 shares at $30, your sale will not be executed if that stock has traded in the sequence $30, $30, $30, $30 1/8, $30, $30, $30. You are not allowed to short it at $30 because the trading price before $30 was $30 1/8. You could short the stock at $30 if the previously traded price before $30 was below $30. If a stock trades $30, $30, $30, $29 7/8, $30, $30, $30 you can short it at $30 since the previous trade before $30 was $29 7/8.
Second, short sellers are often placing buy orders in a falling market. So while the longs are selling, the shorts are providing liquidity to the market by "covering their shorts" and buying stock back. Just as in the commodity markets, short selling improves the efficiency and liquidity of markets.
Is short selling 'unpatriotic'?
No. Short selling involves the trading of stocks in a secondary market. When you buy a stock, you are not "giving" the company your money to invest, you're buying a share of the company from another investor who wants to part with those shares. Likewise, shorting is also done in the secondary market and has nothing to do with the capital allocation process. Shorting is a common (and necessary) practice in the commodities markets, and just as in the commodities markets, short selling enhances market efficiency and liquidity (see above). Some academics have suggested that informed investors who execute short sales help set the upper limit and keep equity markets efficient.
Additionally, short selling reduces the risk of manipulation, and provides liquidity. Some sophisticated investors do not invest in markets that do not have short sellers, because they consider them to be less efficient markets. Their absence tends to let the markets become too highly valued and therefore too prone to crash. The absence of short selling increases the market's volatility.
How does the fund protect investors in stock market declines?
Like most mutual funds, the Prudent Bear Fund invests in a broadly diversified portfolio of securities. But in addition to buying stocks, the fund also engages in "short sales" and buys "put" options. An investor who sells a stock short or buys a put option profits when the stock goes down. The fund also holds short positions on indexes which act as proxies for the stock market or a segment of the market. This portfolio of more "short" than "long" positions (in addition to put options) allows the fund to benefit from a steep market decline.
Why are you bearish?
We believe that the greatest stock market bubble in history has burst and that we are now in a secular bear market where stocks will perform poorly for some time. For more on our views of what led to this bubble and the implications for the U.S. stock market and economy, see our homepage and related links. |
