Live Short and
> Prosper
>
> Why add short selling to your repertoire? Because
> bad news
> knows what it's talking about.
>
> By Susan Lee
>
> Every month, the wall street Journal, The New York
> Times, and
> Barron's carry articles reporting on many of the
> stocks in which
> sizable short positions are held. So what?, you
> say. Well,
> according to a recent academic study, if you had
> owned some of
> the companies so listed and then sold them when
> they appeared
> on the list, you would have done yourself a favor.
> Stocks that
> were heavily shorted underperformed the market on
> a
> risk-adjusted basis.
>
> Paul Asquith and Lisa Meulbroek investigated short
> selling
> between 1976 and 1993. (Reminder: Short selling
> describes the
> funny practice of borrowing a stock, selling it,
> waiting for its
> price to go down, and then purchasing it to "pay
> back" the
> lender; the profit comes in the spread between the
> price at which
> it's sold and the price at which it's bought
> back.) Asquith and
> Meulbroek's paper "An Empirical Investigation of
> Short
> Interest," released in 1995, argues that there is
> a strong negative
> relationship between the amount of short selling
> in a stock and
> the stock's subsequent performance. Simply put,
> stocks that
> attract short-sellers are more likely to go down
> than up.
>
> Moreover, in the 18-year period Asquith and
> Meulbroek
> observed, returns were even more negative for
> firms that were
> heavily shorted for more than a month, both for
> the time the
> stocks were shorted and for the following two
> years.
>
> This is an interesting result.
>
> First, because it flies in the face of the
> conventional wisdom that
> short sales are a bullish--not bearish--indicator
> because they
> indicate future demand; that is, short-sellers
> must eventually buy
> shares to replace their borrowed shares in order
> to cover their
> positions. Second, because it proves what some
> people have
> been saying all along--that short-sellers really
> do know what
> they're doing.
>
> Third, and most important, this study gives
> credence to the
> commonsense idea that since brokers and analysts
> pay much
> more attention to reasons for buying stocks than
> for selling, there
> is more positive than negative news. Thus, stocks
> about which
> there is negative information represent an
> inefficient part of the
> market, making it easier to find profitable
> opportunities on the
> short side than on the long.
>
> Academic theories aside, however, practice shows
> that there
> isn't much interest in short selling. In March of
> this year, for
> example, reported short sales on the New York
> Stock
> Exchange, the American Stock Exchange, and the
> Nasdaq were
> at a near record high of three billion shares, but
> that figure
> represents only a fraction of the 227 billion
> shares held long.
>
> So why don't more investors sell stocks short?
>
> First, regulations governing short selling make it
> more difficult
> than buying long. There is something called the
> uptick (or plus
> tick) rule, which decrees that a short sale can
> occur only at a
> price above the last sale price. There's also a
> zero-tick rule,
> which says that a short sale can occur at a price
> equal to the last
> sale price, but only if the last price change was
> positive. In other
> words, you can't sell short if your target stock
> is going down.
> Then, there are so-called prudent-investor rules
> that prohibit big
> institutional investors, like public pension
> plans, from selling short
> altogether.
>
> Second, short selling is more expensive than
> buying long. Money
> from a short sale is not available to the seller
> but is escrowed as
> collateral for the owner of the borrowed shares.
> (Although large
> short-sellers may receive interest payments,
> called rebates, on
> the sale proceeds, small investors usually do
> not.) In addition to
> the proceeds that stay as collateral,
> short-sellers must deposit 50
> percent of the market value of the shorted shares
> as a margin
> requirement. If the price of the stock goes up,
> the short-seller
> will get a margin call and must deposit more
> funds.
>
> Also, short-sellers must reimburse the owner of
> the stock for any
> dividends that accrue during the period the shares
> are borrowed.
> What's more, there is a tax penalty on success.
> Even if the short
> position is held for more than a year, profits are
> subject to the
> short-term capital-gains tax, which can be more
> than 11 percent
> higher than the long-term capital-gains rate.
>
> Third, short selling is considered dangerous. When
> you take a
> long position in a stock, the greatest risk is
> that it will fall to zero
> and you will lose all the money you paid. Your
> worst loss is
> known and bounded. When you take a short position,
> however,
> the greatest risk is that the price of the stock
> will rise
> forever--meaning there is, theoretically at least,
> no limit on your
> loss.
>
> There is also a danger, especially in a rising
> market, that at some
> point you will be unable to meet a margin call and
> have to
> purchase your stocks at a loss, before your short
> position yields
> a profit. What's more, shorts are vulnerable to a
> squeeze--a
> deliberate attempt by investors who are long in
> the company to
> reduce the lendable supply of shares by madly
> buying them and
> demanding delivery. This pushes up the price and
> forces the
> unfortunate short into the market to buy shares the high price. |
