Bear Tracker's Short Selling FAQ
Table of Contents
What Is Short Selling
How Do I Sell Short?
Why Sell Short?
Why Avoid Selling Short?
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What Is Short Selling?
A short seller sells a stock that he believes will fall in value. A short seller does not own the stock before he sells it. Instead, he borrows it from someone who already owns it. Later, the short seller buys back the stock he shorted and returns the stock to close out the loan. If the stock has fallen in price since he sold short, he can buy the stock back for less than he received for selling it. The difference is his profit.
Short selling allows investors to profit from falling stock prices. "Buy low, sell high" is the goal of both short selling and purchasing shares ("going long"). A short sale reverses the order of a typical stock purchase: the stock is sold first and bought later.
For example, in September 1987, Sally Shortseller thinks IBM is overvalued. She sells short 100 shares of IBM at $175 per share. The stock market crashes in October and IBM's shares fall to $125 per share. Sally buys back 100 shares of IBM and closes out the short sale. She gains the difference between the sales proceeds and the purchase costs and pockets $5,000 from the short sale, excluding transaction costs.
How Do I Sell Short?
Unlike a stock purchase transaction, which involves two parties (the buyer and the seller), short selling involves three parties: the original owner, the short seller, and the new buyer. The short seller borrows shares from the original owner, and immediately sells them on the open market to any willing buyer. To finalize ("close out") the short sale transaction, the short seller must then go out into the stock market and buy the same amount of shares as he sold so that the broker can return them to the original owner.
To sell short you first must set up a margin account with your broker. A margin account allows you borrow from your brokerage company using the value of your portfolio as collateral. The general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction. In other words, If you have $1,000 worth of stock in your margin account, you can borrow $2,000 of stock to sell short.
To sell a stock short, you must borrow stock. To initiate a short sale, you simply call up your broker and ask to sell short a specific number of shares of your selected stock. Your broker then checks with the Margin Department to see whether the shares are available or can be borrowed from another brokerage, usually while you wait on the phone for a minute. If they are available, the brokerage borrows the shares, sells them in the open market, and puts the proceeds into your margin account. To close out your short sale, you tell your broker that you want to buy the same number of shares that you shorted. The broker will purchase the shares for you using the money in your margin account, return the shares and close out the short sale transaction.
While your short sale is outstanding, your account will be charged interest against the value of the short position. If the stock you shorted goes up in price, or the value of the stock you are using as collateral goes down in price, so that your collateral is less than the "maintenance" requirement (usually 30% of the value of the short position) you will be required to add money to your margin account or buy back the stock that you sold short. You must also pay any dividends issued by the company whose stock you sold short.
A short sale cannot occur in a stock that is falling in price. This is known as the "uptick rule" and is an SEC regulation. The rule is intended to prevent short sellers from profiting by driving down the price of an already battered stock through successive waves of sell orders.
Why Sell Short?
The two primary reasons for selling short are opportunism and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level. They believe that the stock price will fall when reality replaces the hype. A short sale provides the opportunity to profit from the overpriced stock. Short sales are also used to protect an investor's portfolio against a market downturn. By shorting stocks that the investor believes will fall sharply when the market as a whole falls, investors can help insulate the value of their portfolios against sudden market drops.
Zitel provides an example of opportunistic short selling. In 1996, Zitel was caught up in a wave of investor enthusiasm because it has a stake in a company that fixes the computer glitch that causes computers to interpret dates in the next century (2000s) as dates in this century (1900s). This problem, known as the "Year 2000" problem, suddenly became a hot topic of conversation and made it to the covers of Time and Newsweek. In September 1996, Zitel was selling for $7 per share. By December, the shares topped $70. At this point, many investors thought the stock was overpriced and saw an opportunity to make money by selling it short. If an investor had sold short in December 1996, he could have bought the stock back for $15 per share in April 1997. Selling short would have allowed the investor to take very profitable advantage of the opportunity presented by the overpriced Zitel stock.
Short selling is also used to protect portfolios against erosion due to a broad market decline. Short sellers make money when stock prices fall. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling.
By shorting carefully selected stocks that are priced near their peak but that will fall sharply if the market falls, an investor can use the profits from the short sales to help offset losses in her long position to protect the value of her portfolio.
For example, Sarah Shortseller has most of her wealth tied up in stocks which she has bought because she expects them to appreciate in price. But she is concerned that the stock market is vulnerable to a sharp drop and wants to protect her savings while staying invested in the market. She knows that market drops are often caused by a change of investor sentiment from optimism to pessimism. She identifies businesses that are not worth much today, but whose stock price is high because people hold high hopes for their future prospects. These stocks should be especially susceptible to a negative shift in sentiment since optimism is what principally drives their stock price. She then sells these stocks short. If investors become more pessimistic and the market falls these stocks should fall more than most. Sally can use the profits from these short sales to offset losses in the rest of her portfolio. This will help her protect the value of her portfolio.
Taxes provide a third reason to sell short, and this is the most common reason investors sell stocks short. Many investors short-sell stocks they already own as a way of locking in profits without having to pay capital gains taxes. This technique is called "shorting against the box." By reversing their long position through a short sale, an investor can lock in the value of the position, without having to sell the stocks and take a capital gains charge. Recent tax law changes may affect the desirability of using this technique.
Why Avoid Selling Short?
Short-selling stock is an extremely high-risk transaction. The potential gains are limited while the potential losses are unlimited. Selling stock short means swimming against the current of price trends rather than with the current, because the long-term trend in stock prices is up. Many of the most successful and most reputable investors do not sell stock short and recommend against it.
The potential gains are limited because the profit from a short sale is capped at the size of the short sale. The lowest a stock can fall is to become worthless so that it costs nothing to buy back the shares and close out the short sale. In this case, the profits equal the proceeds from the original short sale, again excluding transaction costs.
The potential losses are unlimited because a stock can keep going up in price indefinitely. If you sold short some stock and then the stock price doubled, your losses would equal the size of the original short sale. If the stock doubled again, your losses would equal three times the size of the original short sale. If the stock then doubled once again, your losses would equal seven times the original short position.
For example, if you sold short 1,000 shares of Zitel in September 1996 for $7 per share, the most you could make from the transaction would be $7,000 if Zitel had gone bankrupt. By December 1996, however, you would have lost $63,000, or nine times your maximum potential profit, on the transaction when Zitel was selling at $70 per share.
Betting wrong on a short sale can be very costly. If you thought Microsoft was overvalued in July 1994, you could have sold short 1,000 shares at $25 per share. The most you could have made from the sale would have been $25,000 if Microsoft's shares became worthless. If you had closed out your short sale in July 1997 when Microsoft's shares were selling at $150 per share, then you would have lost $125,000 on the transaction.
Stock prices tend to rise over time. The long-term trend of price increases in stocks is over 10% per year. Betting whether a stock's price will go up or down is not like flipping a coin. The odds are not even. Over the long term, stock prices on average have tended to trend up. This is not an accident but the inevitable outcome of our particular brand of market capitalism. The reason people invest their money in shares of a company is because they expect the company to use the money to make profitable investments that will make the value of their stock go up. Betting that a stock will fall in price is betting against the current. It does happen but the odds are against it.
Mainly for these reasons, many of the country's most respected and most successful investors do not sell short and warn others against it. Warren Buffett, who became one of the richest men in America by investing in stocks, does not sell stocks short. Peter Lynch, former manager of Fidelity's Magellan fund and the author of best-selling books about investing, does not sell stocks short and recommends against it. Al Frank, publisher of the top-performing Prudent Speculator investment newsletter, recommends hundreds of stocks for purchase - sometimes on margin - but does not sell stocks short.
So beware. Short selling is extremely risky, can produce large losses, and is avoided by many of the most successful investors of our time.
For advanced short selling advice, click here for the Bear Tracker's Guide to Successful Short Selling.
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