FAQ To Short Selling

FAQ To Short Selling

What is short selling?

A short sale transaction is the opposite of a traditional purchase of a stock. In a short sale, the investor

borrows stock in order to sell it, with the obligation to repurchase the stock later. Instead of profiting if

a company’s shares rise, the investor gains if the company’s shares fall.

Why would I want to short sell?

When you invest in a company, you are predicting that its value will grow over time. If you think a

company’s fortunes are going to decline, however, then you want to sell the company short. Buying a

stock is to invest with a company, shorting a company is to invest against the company. If you have

good reason to think a company will see its prospects fade, short selling is your way to profit from this

knowledge.

Give me an example where I’d want to sell short.

Remember that short selling is investing against a company. So imagine that in 2007, you were

confident that Apple’s iPhone would come to dominate the smartphone industry. You bought stock in

Apple and invested with that firm. For every winner, there’s a loser, and in this case, the losers would

inevitably be the other mobile phone makers. For Palm, Nokia, and Research In Motion, if Apple was

to gain market share, these firms would see their sales decline.

An investor confident in Apple’s prospects could also conclude it was likely that, say, Research In

Motion’s profits would fall and as such, its shares would decline. As it turned out, the general stock

market fell heavily in 2008, so an investor who only owned shares in Apple would have suffered losses

during the decline due to general economic conditions rather than any issues specific to Apple.

However, if you sold short Research In Motion or other mobile phone makers, you would have been

fine, as shares in the other phone makers dropped more quickly than Apple did, earning large profits on

your short sale, hedging your position and sheltering you from the broader selloff in the market. When

the market turned back up, Apple shares resumed their upward climb while the other phone makers

saw their stocks stay in the dumps, widening gains for someone who invested with Apple and invested

against its competitors.

So how does short selling work exactly? What’s a sample trade look like?

Alright. Let’s imagine that you’d realized that Netflix was eating Blockbuster’s lunch in the video rental

space. However Blockbuster shares remained inexplicably high, as the market failed to realize the

company’s impending doom. At this juncture, Blockbuster shares, ticker: BBI, were trading at $10

each. You sell short 1,000 shares of BBI, taking the position that Blockbuster would likely crumble

under the weight of Netflix’s competitive pressure.

Here’s what happens:

You sell 1,000 shares at $10 each. So, you receive $10,000 of cash in your brokerage account. In

return, you now have an obligation to buy 1,000 shares of BBI in the future to make good on your

earlier sale.

The stock subsequently drops to $3 per share. You decide to cash out on your trade. As such:

You buy 1,000 shares x $3 each. You pay out $3,000 of cash from your brokerage account. This retires

the loan of 1,000 shares of BBI that your broker had extended to you.

Net result: You received $10,000 when you sold the stock short and later you paid $3,000 to buy the

shares back. The $7,000 more you received than what you paid to buy the stock back is your profit.

Pure and simple.

Well that seems simple. What could go wrong?

The most common problem is that the stock you’ve sold short goes up. Let’s imagine Blockbuster’s

turnaround strategy had worked and as a result shares rose to $15 each. Now when you go to buy back

your 1,000 share obligation, you have to pay $15,000 (1,000 x $15), leaving you with a $5,000 loss.

And what’s a short squeeze? I always hear people talking about them.

A short squeeze is a market phenomenon that can develop when there are many people betting against

a specific company. When the company announces some new good news, such as a product launch,

winning a lawsuit, or something along those lines, shares rise. Short sellers, now exposed to more

losses as shares keep rising become fearful and start buying the stock to shield themselves from more

losses. Other short sellers watch as the stock’s increase accelerates, and soon it becomes a self-fulfilling

cycle, as shorts panic race to capitulate before the losses mount. Oftentimes traders will start buying the

stock to “squeeze” the stock and manipulate it further upward, profiting from the short seller’s distress.

How do I avoid getting squeezed when I sell short?

Generally, all other things equal, it is better to sell short companies that have fewer other short sellers

involved. A heavily bet against company is more vulnerable to rapid short squeezes than one that

doesn’t have many short sellers involved. Liqudity of the stock is also key, if the stock can be easily

bought and sold in large quantities, it is less prone to short squeezes. Our site focuses on finding

companies that are not vulnerable to short squeezes for our short sale operations.

Beyond that, management of your trades is key. In this educational series we offer much more in-depth

guides to finding good shorts, avoiding bad short-selling situations, and managing our trades properly

to maximize our gains and avoid large losses.

How else can you manage your trades?

Our educational program and investment newsletters also teach and recommend certain strategies

utilizing stock options to contain risk and amplify return from our short sales. In general terms, put

options can be used to profit from a stock’s decline with limited potential for loss. And call options

can be used to protect against unexpected events that can damage a short sale. Say, for example, a

company is unexpectedly acquired, a call option would allow you to protect against a large loss due to

this unlikely and unfortunate event that would otherwise leave the short seller exposed to a significant

risk.


Isn’t it kinda wrong to bet against companies? Isn’t it unpatriotic or something?

Many investors have gotten the misguided the idea that short-selling is evil, or at minimum sketchy and

unscrupulous. This is wholly false. Short selling provides a vital function to the stock market, keeping

markets healthier and more efficiently operating. Politicians and journalists often whimper about

alleged nefarious short selling, particularly after large market sell-offs. These claims are invariably

without basis in fact, however. Short selling helps prevent stocks from becoming wildly overvalued in

the first place. Short sellers expose frauds as well. It was short sellers, not government regulation, that

exposed heinous fraud at Enron and Sino-Forest to name just a couple of examples.

When markets are plunging, however, people tend to forget about the benefits short selling provides

to the market and blame sellers for making stocks go down. But the fact is that numerous academic

studies have shown short sellers simply don’t have any culpability for broad market declines. Markets,

such as China, which have banned short selling see far greater magnitude market crashes than markets

such as the United States and Canada which broadly permit short selling. In 2008, the United States

limited short-selling heavily during the decline to try to stem the losses. On the contrary, the Dow

Jones and other market indices fell much more quickly after short selling of financial stocks was

banned. The search to find a culprit for the crisis had to move to other scapegoats once short sellers had

been vindicated.

But what about naked short selling? That’s bad, right?

Certain segments of the investing populace claim that while normal short selling may be ok, there’s a

related practice called “naked short selling” that can hurt companies. From this premise, they conclude

that short selling is harmful to the stock market and damages the American economy. This conclusion

comes from a faulty understanding of how short selling works. “Naked” short selling is when you sell

short a stock without first borrowing it from your broker. Only a small number of market partcipants

have an exemption that allows them to engage in this behavior, for specific purpose and with regulatory

scrutiny.

Ordinary investors – even large operators such as hedge funds – simply cannot naked short sell. It is

prohibited, and any investor that naked short sells without regulatory authorization is committing a

serious crime. As such is is wholly inaccurate to blame normal short sellers for any supposed results

of alleged naked short selling. Management teams that blame naked short selling for their falling share

prices are usually seeking to distract investors from the real culprit: their faulty businesses.

Is short selling just for stocks?

No, you can sell short in a wide variety of markets. These include commodities such as oil and gold,

stock options, ETFs, bonds, and foreign currencies to name a few. While this site focuses toward

research on the short-selling of common stocks, we also will provide readers recommendations to short

sell in ETFs and options as these opportunities appear.

Why learn about short selling now?

Short selling has been out of favor recently. The market has risen consistently since the 2008 financial

crisis, with stocks almost tripling since then. As such, investors have taken to buying, buying, and

buying stocks yet again. Stocks seem to only know one direction, upward. Yet, when Wall Street

gets sets on one motif, you can be sure that the winds of change lie just around the corner. A famed

economist said that stocks had reached “a permanently high plateau” just months before the Great

Depression began in 1929. Similarly, internet stocks were a sure thing in 1999, and in 2006, it was a

commonly-held belief that “housing prices always rise.”

In 2015, the market has again grown complacent. After years of large gains, investors have bet heavily

on the stock market making further rises. And when many people bet on one outcome, the opposite

result often happens. We aren’t forecasting a new crushing bear market or anything drastic. However

we would urge investors not be lulled to sleep by steadily rising stock market averages. Risk is building

in the market and now is the time to educate yourself on how to protect yourself and even profit when

stocks make their next significant decline.

As the old saying goes, stocks eat like chickens and crap like elephants. Or alternatively put, stocks

climb the stairs and plunge down the elevator shaft. Since stocks have been rising consistently for

many years now and tend to fall rapidly and dramatically after long periods of gradual inclines, this is

the moment to add short selling to your investing arsenal.

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