Short Selling Strategy: Risks and Rewards

The conventional view for the longest time was that the surest way to make money in stocks was to buy and hold them for the long-term. Anyone who thought otherwise was called a speculator, trader or momentum player. It was alleged that "buy and hold" investors were sure-fire winners. But after 2000-2002 bear market, the view of the Investment market changed, hardly anyone believes that “buy and hold” investors are sure winner.

The most widely published evidence that buying and holding is not the best way to make money in stocks was presented in an article printed September 27, 2002 in USA Today. It featured a chart showing the up and down movements of the Dow Jones Industrial Average from 1966 through 1982. The point of the article was that the Dow opened 1966 at 983.51 and closed 1982 at 991.72. Up 8.21 points, less than one-percent, in 17 years!

The USA Today article, Timing is Everything When Stocks Stall showed that there were six bull markets and five bear markets during this period of time. Had you bought the Dow at the beginning of each bull market and gone into cash at the beginning of each bear market, you would have gained 549%. Had you ridden the Dow up in each bull market and sold it short in each bear market, you would have gained 2,680%.

This example clearly shows that buying long in bull markets and selling short in bear markets is a much better strategy than buying and holding stocks for the long-term. So why does the conventional wisdom on Wall Street teach us that "buy and hold" is the best investment strategy? Why does it tell us you can't "time the market," and warn us against selling-stocks short?

The reason is obvious: The Wall Street brokerage houses and mutual funds want to control your money at all times. Selling stocks when prices go down is very bad for business. Not only does it reduce the assets from which they make money, but it drives stock prices lower which makes them look bad.

Brokers tell you to buy, buy, buy because they don't want to offend the companies they represent. They say you can't time the market because it supports the argument of staying long all the time. They are against selling short because it rubs their customers the wrong way. Incidentally, you are not their customer. You are the victim of their clever marketing schemes.

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What is Short Selling?

Have you ever been absolutely sure that a stock was going to decline and wanted to profit from its regrettable demise? Wouldn't it be nice to see your portfolio increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock or during a bear market, thanks to an advanced investing technique called Short Selling.

Short selling is a trading strategy, which is neither terribly complex nor entirely simple. In other words, it's a concept that many investors have trouble understanding. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. When an investor goes long on an investment, it means she has bought a stock believing its price will rise in the future.

Conversely, when an investor goes short, he is anticipating a decrease in share price. Investor makes money only when a shorted security falls in value.

Sounds good, but selling stocks short involves selling something you don't own. Somehow this has a bad ring to it. How can you sell something you don't own? Don't worry about it. It's done every day. For example, you subscribed to an investment newsletter. The publishing company did not have next month’s issue printed when they took your order. So they actually sold next month’s issue of the newsletter short.

Now the publisher has the responsibility of putting the newsletter together and delivering it to you as promised. You expect that they will because they have done it over and over before, but you have taken a risk.

The publishing company also took a risk in accepting your order. They have to get the newsletter to you at a profit. Otherwise they eventually will go broke. In summary, you took a risk in buying something the provider didn't have. The provider took a risk in delivering it at a profit. Most businesses are run this way. So selling short is NOT a bad thing.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept.

Here is how it works

When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account.

Sooner or later you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

The selling of a security that the seller does not own is called a short sale. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Short Selling is a trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.

A market transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares.

Suppose 1,000 shares are short sold by an investor at $25 apiece and $25,000 is then put into that investor's account. Let's say the shares fall to $20 and the investor closes out the position. To close out the position, the investor will need to purchase 1,000 shares at $20 each ($20,000). The investor captures the difference between the amount that he or she receives from the short sale and the amount that was paid to close the position, or $5,000.

Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't have, and so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as “Being Called Away”. It doesn't happen often, but is possible if many investors are selling a particular security short.

Since you don't own the stock (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.

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There are two main motivations to Short Sell a Stock :

1. To Speculate

The most obvious reason to short is to profit from an overpriced stock or market. Probably the most famous example of this was when George Soros "broke the Bank of England" in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion.

2. To Hedge

For particular reasons, very few sophisticated money managers use short selling as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.

There are some restrictions on the size, price and types of stocks you are able to short sell. For example, many brokers impose large margin requirements on clients who short stocks with a market price that is less than $5.

Before July 2007, the Securities and Exchange Commission had “Up-tick Rule (also termed as zero plus tick rule)”. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines. This rule is now eliminated.

The whole idea of selling stocks short is to make money from stocks that are going down in price. It's the exact opposite of buying stocks long expecting that they will go up in price. In selling short, you sell stocks that appear to be high in price and buy them back at lower prices.

For example, let's suppose ABC is trading at $30 per share. You think it could go down to a lower price. So you call your broker and say, "I want to sell 100 shares of XYZ at $30 per share or higher to open." You can make transaction on most of the online brokerages which will have a check box that says "short sale."

Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you want (just as with buying long). You can think of the outcome of a short sale as basically the opposite of a regular buy transaction.

Short selling is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling provides a sizable opportunity with a hefty monkey of risk on its back.

You need to have a margin account in order to sell stocks short. A margin account allows the broker to extend credit to you in accordance with Federal Regulation T of the Federal Reserve Board. If you do have a margin account and you place an order to sell short, the broker will check to see if you have sufficient cash in your account to satisfy Reg T.

This means that you must have at least 50% of the amount involved in short-selling the stock in your account as cash. This cash shows that you have sufficient funds available to buy the stock back should it go against you.

Once the broker verifies that you have sufficient cash in your account to make the trade, he or she will borrow the requested shares of stock, and credit your account for the amount received from selling the stock.

For Example, In the case of selling short 100 shares of ABC at $30, you would need to have half or $1500 cash in your account and you would receive a credit of $3000 less commissions. Overall, you would have a credit balance of $4500 in your account.

Can you go out and spend this money? Not on your life. At least not until the price of the stock starts going down. Let's suppose ABC goes to $20 per share. You've made $1000. Your credit balance is still $4500, but the market value of the stock is only $2000. So your equity is $2500, ($4500 - $2000). Although your paper profit is $1000, but your buying power is now $2500. This is the amount you can spend to buy stocks long or sell stocks short.

Although you will always pay interest on money you borrow from the broker, most brokerage houses do not pay interest on the proceeds of short sales. You may, however, be able to negotiate an interest payment if you have a sizeable account. You will also be charged by the broker for any cash or stock dividend payments on your short positions.

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How to Manage Risk on Short Sale?

The potentially unlimited loss associated with a short sale makes it important to proactively manage the risk.

Just as a sell-stop or trailing sell-stop orders can help control losses on a long purchase, a buy-stop or trailing buy-stop order can help to manage loss on a short sale, in case the stock price goes up.

For a short sale, buy-stop orders trigger a market order to buy back when the ask price is equal to, or greater than, the stop price entered.

A trailing buy-stop involves an entered dollar or percentage amount above the current market. If the ask price only moves upward (against you), the trailing stop will track the ask price until it reaches or surpasses your entered trailing amount. However, unlike the standard buy-stop order, when the price moves downward (in your favor), a trailing buy-stop will readjust the trigger price from the new low ask price reached.

Questions to Ask Yourself Before Short Selling Stocks

Before you even began to sell stocks short there are a couple questions that you should ask yourself. Don’t start thinking about “how to short a stock and make big bucks” until you can say yes to these questions.
1. Am I Eligible to Short Stocks? Is my trading account not for long only trades?
2. Do I have Any Experience with Short Term Trading?
3. Am I comfortable with Short Term Trading?
4. Do I have a Plan, a reason to short a stock?

Illegal Short Selling

As of 2009 Naked Short Selling is illegal. This is simply selling a stock without having something to back it up with (like a borrowed stock). Your broker should take care of this, so you don’t have to worry about breaking a law.

What it does mean for you, is that you can only short stocks that your broker has available. So make sure if you are going to short a stock that your broker has some of it in reserve, otherwise your order will not get filled.

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