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TRADER'S NOTEBOOK


Get Shorty

07/31/09 11:24:13 AM PST
by John Devcic

It's been called un-American. What about short-selling triggers a reaction like that?

Short-selling, or shorting, as it is most commonly referred to, has been called morally wrong and un-American. Shorting is considered a four-letter word among most investors and politicians. Regardless of that, shorting is a well-practiced trading technique among investment professionals. Shorting is a simple strategy ignored by most investors. Ignoring shorting does not make it go away. Although you may not be interested in short-selling stocks, understanding its place in the market as well as its effect on stocks is crucial. Let's take a look at shorting and try to dispel the confusion that surrounds it.

SHORT-SELLING
You sell short a stock when you believe that a security will fall in value. Shorting allows you to profit from a stock whose price is declining. Hedge funds, for example, will use shorting as a way to protect their exposure to downside risk. Shorting is counterintuitive for most investors who are more interested in capturing the upside.

When it comes to going long, it is said that a security has unlimited upside potential and limited downside risk. The downside risk would be the security falling in value. Selling short is the opposite of going long. When you go long, you are bullish on the future. Short-sellers are bearish so when you short, your profit is limited to a stock falling to zero, and your loss is potentially unlimited. Let's use as an example a fictional company called ABC Corp. You learn that ABC's chief executive officer has left the company for unknown reasons. You want to short the stock. You decide to sell ABC at $10 and short 1,000 shares for a total of $10,000. After a few days, ABC falls to $5 a share and you decide to buy it back. You buy ABC at $5 for a total of $5,000, pocketing a $5,000 profit.

While the principle of shorting is pretty simple, the process itself is a little more complicated. When you want to short a stock, you will need to borrow the stock you want to short from a broker. This is no easy task. Banks and brokerage firms can have parts of their operation dedicated to finding shares of stock for investors to short.

When those shares have been found, you will receive a confirmation from the broker. You can then short those shares. The stock you have borrowed usually come from investors who own the shares and allow them to be borrowed. Once a short position has been initiated, the goal is simply to make money as the price of the stock falls. Your ultimate goal is to purchase the shares back at a significantly lower price than you originally paid.

NAKED SHORT-SELLING
The distinction between a legitimate short and a naked short is a small one. While small, it is important to note that in naked short-selling you sell short shares of stock that you do not own, do not have secured, or even intend to secure. This practice is illegal. While it is true that many short positions are opened before the seller has the stock in hand, they have at least waited till a broker has given confirmation.

THINGS TO KEEP IN MIND Shorting may be a new concept for many of you. There are numerous things about shorting that you will need to keep in mind. Most of these points will seem obvious, while you may never have heard of some others. Either way, they are important factors to keep in mind:

  • The lender can call back the lent securities at any time. If this happens, you will have to go into the market and buy them back immediately. It makes no difference if your short position is profitable. Once called, you will have to buy back those shares at their current market price.
  • Your broker must confirm that the security can be delivered to you. You will want to make sure the broker can get access to stock before you short that stock. The broker will give you confirmation that they have secured the shares you are looking to short.
  • Days to cover (DTC). This is a numerical representation of how many total shorts of a particular stock there is in the market currently and how long it would take in terms of trading days to cover those short positions. For example, say that ABC has two million shares of its stock shorted. Now you need to look at the average trading volume, which for this example is one million shares. Using simple division, you know that it would take about two trading days to cover all of the shorts on ABC (two million shares short divided by one million shares traded per day).
  • Short interest. This tells you the total number of shares sold short. This is usually a percent of float. Float is simply the number of shares available for trading. This is a good indication of the amount of bearishness that the stock currently has on it.
  • Short squeeze. This is when the stock is moving higher and short-sellers are scrambling to get out of their positions because demand for the stock has increased. However, the problem is that supply cannot keep up with the demand. The short-sellers have to get out quickly, selling at higher prices. This will result in even higher stock prices without any fundamental reason, as short-sellers have to close their positions.
  • Dividend. If you short a stock that pays a dividend and you short it prior to the ex-dividend date, you will be responsible for paying the dividend to the owner of the stock.

SUMMATION
The idea of shorting, which was once the tool of hedge funds and daytraders, may also be a strategy for the self-directed investor. Shorting is a simple strategy ignored by most nonprofessional investors. Ignoring it does not mean it will cease to exist or, more important, cease to have an influence on the stocks you own. While you may not be interested in short-selling for profit, you know how to identify its effects on the stocks in your portfolio. It would benefit any self-directed investor to know the short interest on a particular stock. Short interest can be looked at as a hurdle that the stock will need to get over in order to move higher.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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