Short Selling-The Basics

I’ve gotten a few questions about short selling recently and there is some interest, some trepidation, and some misunderstandings. When you are short you have borrowed shares from another entity and sold them in anticipation of a decline in stock price. At a later date you will buy them back, hopefully at a lower price and the difference between what you sold them for and what you bought them for is your gain or loss. I think having the ability to be short in stocks is essential for traders. I’m short perhaps not equally as I am long, but almost always I have a short position in the portfolio, it is part of my diversification. The stereotypical concept is buy low and sell high, well short selling is the same only you sell high first and buy low second. I feel it is far easier for a stock to rapidly meltdown than it is for it to rapidly appreciate. Briefly, to go short you’ll have to setup a margin account with your broker and this usually requires a minimum account balance that is generally a little higher than normal (Scottrade requires $2500 whereas a normal account I believe is $500). It’s no big deal, call your broker and they’ll tell you what to do. When you short you’ll have to put up a minimum of 50% collateral. Next you find a stock that you think for whatever reason is going to decline in price and when you have an entry you like you simply place an order to sell short. Easy as that, just like a buy or a sell. Your broker will then lend you or will go out and borrow the shares and they’ll be sold just as if you were selling, in other words you can sell at market or use limit orders, ect. The catch is the uptick rule which more or less was put in place after the 1929 Crash to prevent shorts from driving a stocks price down. In a nutshell, you have to sell at a price higher than the previous price. You need an uptick before you can get your order executed. To keep it simple, when the price drops, you “buy to cover”, meaning you are repurchasing the borrowed shares that you previously sold and they are returned to the lender. Occasionally a stock will not be able to be shorted or may not be available to be borrowed or sometimes in the middle of your profitable run the broker will call and tell you they can’t borrow the shares anymore and you must cover. There are a few common misconceptions: your risk is unlimited while you potential gain is limited. Remember I said you have to have a minimum of 50% collateral, if the trade is going against you and the price is rising, you are going to get a margin call from your broker to put up more collateral, it’s not like they are just going to mind their own business and let the trade go up unchecked, remember the other amount up to 50% is in the form of margin money they loaned you. So a run away stock costing you your life savings is not a big concern unless you are foolish enough to keep adding money to meet the margin call. Second your profit in a short sale is not limited to a 100%, it is virtually unlimited. The mechanics of this are a little long to go into here, but if the price is moving down it is adding equity to your account which can be used to pyramid your position adding more shares without using anymore margin. You could easily have a gain of 200% or more. There are those who feel short selling is bad form. You’ll have to make that judgment for yourself. I don’t think there is anything wrong with saying this company is overvalued and putting your opinion to work in the market, isn’t that what you are doing when you buy a long position, becoming part of the consensus of a stocks value at a particular point in time? When you go and order that new silver BMW, with black leather and a manual transmission, you know the one the dealer doesn’t have in stock but he just sold you and ordered from the factory, do you know what just happened? The dealer just sold short a car, same concept. Short sellers are an essential part of the market place providing needed liquidity. As a matter of fact some investors will not own a stock that does not have a healthy short presence. Why? Because short sellers are a necessary part of an efficient market, you wouldn’t want to buy a stock pumped up on “irrational exuberance” would you? Besides, a short sale is a future commitment to a buy, the sale must be covered, the shares must be bought in the future just like the car must be bought by the dealer. An additional thing to be aware of, last I knew a short transaction no matter how long it is held is not eligible for long-term capital gains. Well there you have it, feel free to leave any questions or comments in the comments section and don’t forget to go to the bottom of the page and sign up for email updates. Have a great weekend!