Investing in the Stock Market: Part Four

Short Selling

Short selling is relatively complicated compared to conventional buy-and-hold transactions and involves many unique risks and pitfalls. As always, the investor faces high risks for potentially high returns. It is important to understand how the short sale process works before entering a short sale order.

What Is Short Selling?

When an investor is “long” on a stock, it means that he or she has purchased a stock expecting its price to rise in the future. Conversely, when an investor goes “short,” he or she is expecting a decrease in share price.

Short selling entails selling stock that one does not own. More specifically, the seller sells the stock without owning it and promises to deliver it in the future. When a stock is sold short, the brokerage firm will lends it to the account owner. The stock will come from the brokerage firm’s own inventory, from a firm customer, or from another brokerage firm. After the order is entered, the shares are sold and the proceeds are credited to the account. To “close” the position, the same number of shares must be bought or “covered” and returned to the firm. If the price of the stock drops, shares can be bought back at the lower price and a profit is made on the difference. If the price of the stock rises, and shares are bought back at the higher price, a loss will be incurred.

In most cases, a short position can be held for as long as the investor desires, but the margin account will incur interest charges, so keeping a short sale open can be costly. However, short sellers can be forced to cover if the brokerage firm wants the borrowed stock back. This is known as being called away, and it occurs because brokerage firms cannot sell what they do not have, so the short seller will either have to come up with new shares to borrow or cover the position. Being called away does not happen often, but it is possible if many investors are short selling a particular security.

Since the short seller does not actually own the stock, the lender of the stock is entitled to any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, twice the number of shares is owed but at half the price.

Why Short?

Generally, the two primary reasons to enter into a short position are to either speculate or to hedge.

Speculating

Speculators watch for opportunities in the stock market to make a quick, big profit, but it is not without risk. Because of the risks involved, speculation has been likened to gambling and is perceived negatively. However, speculation can involve a calculated assessment of stock market risks and can be profitable when the odds appear to be favorable. Speculating is distinguished from hedging because speculators purposefully assume risk, whereas hedgers seek to mitigate or reduce it.

Speculators can bring certain benefits to the market, such as increased trading volume and market liquidity. However, an irrational amount of speculation can contribute to an economic bubble and stock market crash.

Hedging

The majority of investors employ short sale transactions for hedging. When investors hedge, they are protecting a long position with an offsetting short position, much like a form of insurance. However, hedging can also be expensive, and a basis risk can occur.

Restrictions

A number of restrictions govern the size, price and types of stocks traders are able to sell short. For example, penny stock short sales are prohibited, and most short sales must be executed in round lots. The Securities Exchange Commission (SEC) employs restrictions to prevent stock price manipulation.

As of January 2005, short sellers are also required to comply with “Regulation SHO,” which modernized the rules overseeing short selling and sought to provide protection against “naked short selling.” For instance, sellers had to show the location and availability of the securities they intended to short. Regulation SHO also created a list of securities displaying high levels of failures to deliver.

In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule required that short sale orders be entered at a higher price than that of the previous trade. The rules intention was to prohibit short sellers from contributing to the downward momentum of a sharply declining stock. The rule has been in existence since the creation of the SEC in 1934.

One year later, the SEC put a stop to market manipulations resulting from dispersion of negative rumors about a company. The SEC’s goal was to renew confidence in the wake of the credit crisis. For one month, the SEC did not allow naked short selling on 19 major investment and commercial banks, which included Fannie Mae and Freddie Mac.

In September of 2008, the SEC took further action to minimize abuses. One notable action was the halting of short sales in shares of 799 corporations. The ban ended after a bailout plan worth $700 billion was passed in October 2008.

Who Shorts?

Short sellers are often portrayed as pessimists who are rooting for corporate collapse, but they have also been described as studied, disciplined and confident in their decisions.

Short sellers are typically:

  • Wealthy sophisticated investors,
  • Hedge funds,
  • Large institutions, and
  • Day traders

Short selling involves a great amount dedication to market and company analysis. The very basics that must be understood include:

  • The nature of securities markets,
  • Trading techniques and strategies,
  • Market trends, and
  • The company’s business operations

The Transaction

Suppose that after hours of detailed research and analysis, company XYZ is presumed dead in the water. The stock is currently trading at $65, but research and analysis results show it will trade much lower in the coming months. In order to capitalize on the anticipated decline, shares of XYZ stock are shorted. The following is how the transaction would unfold:

Step 1: Open a margin account. Recall, a margin account allows one to borrow money from the brokerage firm. The investment(s) in the account will function as collateral.

Step 2: Place the order by calling the broker or entering the trade online. Most online brokerages will have the option to select “short sale” and “buy to cover.” In this case, the order is to short 100 shares.

Step 3: Depending on availability, the broker will borrow the shares. According to the SEC, the shares the firm borrows can come from either:

  • The brokerage firm’s own inventory,
  • The margin account of one of the firm’s clients, or
  • Another brokerage firm

Margin rules and applicable fees and charges should be considered. For instance, if the stock pays a dividend, the person or firm making that loan must be paid.

Step 4: The broker sells the shares in the open market. The profits, if any, from the sale are then put into the margin account.

Short selling can be profitable investment strategy, but there is no guarantee the price of a stock will move in favorable direction. To hedge this risk, shorter sellers use a number of indicators such as metrics and ratios to search for candidate stocks, while others look investigate for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to short selling that is worth mentioning is “short interest.” Short interest is the total number of stocks that have been sold short and not repurchased to close the short position. It serves as a barometer for market breadth. So, a higher the short interest translates to a more bearish outlook by investors.

The Risks

One thing should be made clear: shorting selling entails some unique risks. For example:

  1. Short selling is equivalent to gambling. History has shown that most stocks trend upward; i.e., over the long run, most stocks appreciate in price. Even if a company’s performance does not warrant price appreciation, inflation should drive its stock price up. Therefore, shorting is betting against the overall direction of the market and can become risky if the position is held open for a long period of time.

  2. Short sale losses can be infinite. A short sale position loses money when the stock price rises, and stocks have (theoretically) unlimited upside potential. For example, if 100 shares of stock are shorted at $65, but the share price increases to $90, losses amount to $2,500. On the other hand, a stock cannot trade below 0, so profit potential is limited to 100% in a short sale.

  3. Shorting stocks involves borrowed money. When short selling, a margin account is opened, money is borrowed from the brokerage firm, and the stock is used as collateral. Just as in “going long” on margin, the minimum maintenance requirement of 25% must be met. If an account goes below the minimum maintenance, a margin call will occur and an additional deposit will be required or liquidation will occur.

  4. Short squeezes can wring the profit out of your investment. When stock prices go up, short seller losses increase as sellers rush to buy the stock to “cover” their positions. In turn, the rush to cover creates a high demand for the stock driving up the price even further. This phenomenon is known as a “short squeeze.” Short squeezes are typically triggered by market or company specific news, but sometimes professional traders who notice a large number of shorts in a stock will attempt to induce a short squeeze. Therefore, shorting a stock with a high short interest is not recommended.

  5. Timing. The final complication timing. Even if a company is overvalued, it may be too soon to take a short position. While waiting for the stock to depreciate in value, the short position may be vulnerable to interest, margin calls and being called away.

The dot.com bubble is a perfect example of the timing complication. Short sellers could have made a killing if they shorted the market in the beginning of 2000, but many believed that stocks were grossly overvalued in 1999. However, the NASDAQ was up 86% in 1999 even though two-thirds of the stocks declined. Therefore, shorting the NASDAQ in 1999 would have probably resulted in a complete loss of principal. It was not until 2002 that the NASDAQ returned to 1999 levels.

Market momentum is very powerful. Therefore, traders going against the trend should proceed with caution. One big shorting mistake is all it takes to mount up losses.

Conclusion

Investing in the stock market can be rather complicated, and most brokers are not as knowledgeable or trustworthy as one might be led to believe. Buying on margin or engaging in short selling further complicate investing in stock if one does not understand or know how to mitigate the risks. As a result, investments in stocks can be mismanaged, misrepresented and unsuitable and offered and sold in violation of federal and state securities laws or breach in of a broker’s fiduciary duty. Stockbrokers can also be held responsible for their negligence and failure to abide by financial industry rules and regulations. At the Law Offices of Robert Wayne Pearce, P.A. we understand the nature, mechanics and risks of investing in stocks, as well as the applicable laws, rules and regulations governing those investments. Please contact us for a free consultation if you believe you have suffered damages due to a broker’s misconduct in connection with your stock market investments.

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