How to Short Stocks – and Avoid Disaster

What It's About

Short selling is a gamble and losses can be infinite. Short-sellers beware.

Everyone knows you can make money owning stocks when they go up. Less well known among the general public is that you can also make money when stocks decline through a process called short-selling. It’s a practice that’s filled with controversy.

For a complete rundown on what short-selling is: See What is Short-Selling?

How do you short a stock?

Short-selling a stock is like the reverse of buying, or “going long,” a stock. When you go long, you buy the stock and then sell it later, ideally for a profit. In a short sale, you sell the stock before later buying it back. Your first question might be: How do I sell a stock I don’t own?

The answer: your broker helpfully allows you to borrow stock from other customers. For this privilege, you’ll pay a fee called the cost of borrow. It usually is just a few percent annually of the total stock borrowed, although in exceptional circumstances when the stock is in short supply, the cost of borrow may skyrocket to 20% or even more.

Some investors buy put options rather than short stock directly. That avoids the potential for uncapped losses, but it also means you have to time the stock’s decline, or you’ll end up with an option that’s worthless.

To short stock, your broker will require you to have a margin account. Because you’re borrowing stock from the brokerage, you’re taking on a loan, which the broker will charge you interest on.

Because you’re borrowing, you’ll also need sufficient equity in the account to make the trade. By law, you’ll need at least 50% of the short position’s value in equity. Once the short has been opened, though, you’ll need to maintain at least 25% of the short position in equity, according to the stock exchanges. However, each individual brokerage may have different rules and requirements, depending on your account and the riskiness of the stock’s you’ve shorted.

Another caveat: if you’ve shorted a stock that pays a dividend, then you’re on the hook to pay it back. In practice, the broker simply adds this dividend is to your margin loan.

Unlike going long, where your losses are capped at whatever money you put into the trade, the potential loss on a short is uncapped. The stock can simply continue to rise indefinitely, and the short seller must eventually return the stock to the investor who loaned it by repurchasing it. As the old Wall Street saying goes: “He who sells what isn’t his’n must buy it back or go to prison.”

Some investors buy put options rather than short stock directly. That avoids the potential for uncapped losses, but it also means you have to time the stock’s decline, or you’ll end up with an option that’s worthless. So that adds an extra layer of difficulty onto an already difficult process.

How to not short-sell

Sometimes it’s just as helpful to know what NOT to do as it is to know what to do. As legendary investor Charlie Munger – the investing partner of the even more legendary Warren Buffett – says: “Invert, always invert.” So here are some things you probably shouldn’t do when shorting.

Another helpful piece of advice: When shorting, you make just as much money on a stock that declines from $40 to $20 as you do on a stock that declines from $20 to $10. It’s still the same 50% gain. You don’t have to be first to short the stock in order to make a good profit.

Avoid shorting fads (at least until they’re broken)

Fads are one of the most popular targets of short-sellers, but fads have a way of sometimes sticking around much longer than anyone anticipates. Remember UGG boots – they put the UGG in ugly? That fad started in the early 2000s and has grown since then. While many fads eventually die out – think Heelys shoes – there are some that stick around. Crocs anyone?

That’s why it’s important to avoid shorting fads while their growth is still accelerating. If the fad breaks down, as most do, there will be plenty of time to short them as they decline. But if the fad continues for much longer, your short position could really burn you.

Avoid shorting irrationally priced stocks

There’s an old Wall Street saying: “The market can remain irrational longer than you can remain solvent.” It’s a reminder that stocks that are priced irrationally can continue to be priced irrationally and even rise from there. That makes sense: you can’t force the stock market to accept reasoned arguments when it’s already willing to act irrationally. Some stocks simply capture the public’s attention and imagination, and nothing seems to hurt them.

To avoid the potential downside of shorting – to avoid your own insolvency – wait until the stock’s trend has broken and the market comes back to its senses. If a stock is truly irrationally priced, the stock will almost certainly come back to earth. And again, you make as much money from $40 to $20 as you do from $20 to $10.

Avoid shorting stocks that are “too expensive”

Many rookie investors will short stocks that look too expensive on traditional valuation methods – such as the price-to-earnings ratio – and think the stock must come down again. This can be a huge error, especially if the company continues to grow quickly. For example, Amazon reported losses or meager earnings for years, while its stock skyrocketed. Amazon’s sales growth overshadowed its losses, and the company continued to create value even without showing a profit.

You have to avoid this situation entirely, or your portfolio will really hurt badly.

Popular short-selling targets

While these are three situations that investors need to be very careful with, a couple others are much more popular and time-tested, though it takes a lot more work to find them.

Target #1: Frauds

Stock frauds are often worth nothing, but it can be hard to find them due to the extensive research required. And it’s not so common to find a stock listed on a major U.S. exchange that’s a complete fraud, even if companies sometimes have fraudulent activities that drive their stocks lower.

Frauds are much more common among small companies traded on the pink sheets, though there are plenty of good companies there, too. One key place to look for fraudulent companies is in the world of penny stocks, especially those that are promoted by unknown salespeople.

Target #2: Earnings Manipulators

Short-sellers also look for companies that are manipulating their earnings, but not necessarily in a fraudulent way. These companies may have solid businesses but aggressive managers may be doing things that make the business look much better than it is. In this case, these companies probably won’t go to zero, but may nevertheless see a substantial decline.

For example, analysts may hunt for companies that aggressively book revenue at the end of a quarter, or what’s called “stuffing the channel.” Here managers are looking to make their quarterly numbers and have enticed customers to buy at the last minute in order to do so.

But this last-minute effort often pulls forward sales from the next quarter, leaving managers on a faster-turning treadmill for future quarters. Eventually, they can’t pull forward any more sales, the company misses analysts’ expectations, and the stock declines. Short-sellers profit.

The controversy around shorting

Does shorting sound complicated and so much harder than just buying stock? Well, it is, and that’s why short-selling tends to be the province of well-informed and sophisticated investors and not an area that the general public knows so much about. This ignorance has led to a number of misconceptions about short-selling, including the following:

  1. Critics, including many investors, think that shorting stocks is manipulation.
  2. Critics say that short selling is un-American.
  3. Critics say short sellers are hurting their business.

But short-selling actually helps stabilize markets by providing more information about a company and its prospects. There’s nothing that says the only positive news gets to be reported. This negative information keeps stocks from running up too much, and helps the market more accurately price securities. And shorts help find fraud, aggressive accounting, and poorly run organizations, clearly valuable functions that protect many investors from harm.

Finding the right price is the function of markets – not to stuff uninformed investors with overpriced shares. That’s why controversy over short-selling can be exaggerated or misguided.

By Connor Round
Wealthbase Contributor

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