Passed on from a FRIEND
++++++++++++++++++++++++++++++++++++++++++The Fool FAQ
Shorting Stocks
Many times on the Fool boards I've seen references to
`selling a stock short' or `taking a short position.'
Will someone tell me plainly what shorting is?
An investor who sells stock short borrows shares from
a brokerage house and sells them to another buyer.
Proceeds from the sale go into the shorter's account.
He must buy those shares back (cover) at some point in
time and return them to the lender.
Thus, if you sell short 1000 shares of Gardner's
Gondolas at $20 a share, your account gets credited
with $20,000. If the boats start sinking---since David
Gardner, founder and CEO of VENI, knows nothing about
their design---and the stock follows suit, tumbling to
new lows, then you will start thinking about
"covering" your short there for a very nice profit.
Here's the record of transactions if the stock falls
to $8.
Borrowed and Sold Short 1000 shares at $20: +$20,000
Bought back and returned 1000 shares at $8: -$8,000
Profit: + $12,000
But what happens if as the stock is falling, Tom
Gardner, boatsmen extraordinaire, takes over the
company at his brother's behest, and the holes and
leaks are covered. As the stock begins to takes off,
from $14 to $19 to $26 to $37, you finally decide that
you'd better swallow hard and close out the
transaction. You do so, buying back shares of TOMY
(new ticker symbol) at $37.
Here's the record of transaction:
Borrowed and sold short 1000 shares at $20: +$20,000
Bought back and returned 1000 shares at $37: -$37,000
Loss: -$17,000
Ouch. So you see, in the second scenario, when I, your
nemesis, took over the company, you lost
$17,000...which you'll have to come up with. There's
the danger....you have to be able to buy back the
shares that you initially borrowed and sold. Whether
the price is higher or lower, you're going to need to
buy back the shares at some point in time.
To learn more about short selling, try reading the
following books: "Tools of the Bear: How Any Investor
Can Make Money When Stocks Go Down" - Charles J. Caes;
"Financial Shenanigans: How To Detect Accounting
Gimmicks & Fraud" - Howard M. Shilit; "When Stocks
Crash Nicely: The Finer Art of Short Selling" - Kathry
F. Staley; "Selling Short: Risks, Rewards and
Strategies for Short Selling Stocks, Options and
Futures" - Joseph A. Walker. None of these are perfect
in their coverage of short selling but each has its
strengths.
Shorting, unlike puts, seems to have an unlimited
downside potential, correct? That is, hypothetically,
the stock can rise to infinity. Puts, besides the time
limit, have a limited downside. Why then, for a short
term short, would anyone short instead of purchasing
puts?
Theoretically, yes. In reality, no. Because in our
number system we count upwards and don't stop, we
opine that because numbers go on forever, so can a
stock price. But when we think about this objectively,
it seems kind of silly, no? Obviously a stock price,
which at SOME point reflects actual value in a
business, cannot go on to infinity.
Yes, puts do have a limited downside. However, options
have an expiration date, which means that they are
"time-wasting assets". They also have a "strike price"
which means that you need to pick a price and then
have the stock below it on expiration date. Finally,
you have to pay a premium for an option and if you are
not "in the money" more than the premium, by
expiration day, you still lose. So, with options, not
only do you have to be worried about the direction of
the stock, you need to be correct about the magnitude
of the move and the time in which it will happen. And
even then, even if you successfully manage all 3 of
these things, you can still lose money if you don't
cover the premium. Not very Foolish. With shorting,
you only really need to be concerned about direction.
As for limiting liability, you can do that yourself by
putting in a buy stop at a price where the loss is
"too much" for you.
What is short interest? Does it have anything to do
with short attention spans?
Pardon? Short interest? Oh yes! Ahem, short interest
is simply the total number of shares of a company that
have been sold short. The Fool believes that the best
shorts are those with low short interest. They present
the maximum chance for price depreciation as few short
sales have occurred, driving down the price. Also, low
short interest stocks are less susceptible to short
squeezes (see below). Short interest figures are
available towards the end of each month in financial
publications like Barron's and the Investor's Business
Daily.
The significance of short interest is relative. If a
company has 100 million shares outstanding and trades
6 million shares a day, a short interest of 3 million
shares is probably not significant (depending on how
many shares are closely held). But a short interest of
3 million for a company with 10 million shares
outstanding trading only 100,000 shares a day is quite
high.
I've heard the term 'days to cover' thrown around
quite a bit. Does 'days to cover' have anything to do
with short interest?
Yes, it does! Days to cover is a function of how many
shares of a particular company have been sold short.
It is calculated by dividing the number of shares sold
short by the average daily trading volume.
Look at Ichabod's Noggins (Nasdaq:HEAD). One million
shares of this issue have been sold short (we can find
this number, called the short interest, in such
publications as Barrons and the IBD). It has an
average trading volume of 25,000. The days to cover is
1,000,000/25,000, or 40 days.
When you short a stock, you want the days to cover to
be low, say around 7 days or so. This will make the
shares less subject to a short squeeze, the nightmare
of shorters in which someone starts buying up the
shares and driving up the share price. This induces
shorters to buy back their shares, which also drives
up the price! A short days to cover means the short
interest can be eliminated quickly, preventing a short
squeeze from working very well.
Also, a lengthy days to cover means that many people
have already sold short the stock, making a further
decline less likely.
What effect does a large short coverage have
(generally) on the stock`s price? Generally, heavy
buying increases the price while selling decreases it.
Assuming the stocks price has been steady, or
climbing, and many shorters attempt to cover their
losses, how will this affect the price?
What you are referring to, in investment parlance, is
a "short squeeze." When a number of short sellers all
try to "cover" their short at the same time, that does
indeed drive the stock up.
Our approach when shorting is therefore to avoid in
general stocks that already have a fairly hefty amount
of existing short sales. We try to set ourselves up so
we'll never get squeezed.
I'll point out that short squeezes can be the result
of better than expected earnings or some other
fundamental aspects of a company's operation. They can
also be the result of direct manipulation. That is,
profit-seeking individuals with large amounts of cash
at their disposal can look on a large short position
in a stock as an invitation to start buying, driving
up the share prices, thus forcing short-sellers to
cover. This in turn drives up the price, and before
you know it, the share price has soared!
OK, I understand the potential benefits and risks of
shorting, except for one thing. If the stock I've
shorted pays a dividend, am I liable for that
dividend?
Yes. If you are short as of the ex-dividend date, you
are liable to pay the dividend to the person whose
shares you have borrowed to make your short sale. I
must say, however, that if you are correct in your
judgment to sell the issue short, your profits
achieved thereby will certainly outweigh the small
dollar amount of the dividend payout.
What happens if the stock I've shorted splits?
MF Swagman replies:
Let's say we're speaking of a two-for-one split. In
that case, all that happens is that you must cover
your short position with twice as many shares as you
opened it. If you shorted 100 shares, you must cover
with 200. Don't forget, though, that the magnitude of
your investment hasn't changed, for while you now have
twice as many shares, each one is only worth half as
much as before! So, while your original cost basis for
the 100 shares may have $36, now, with 200 shares, it
is only $18.
This is a very foolish question, I'm sure, but if I
sell short I am essentially borrowing the shares from
someone else through my broker. Assuming that the
lender does NOT need the shares prematurely, what
determines how long I can stay short? (pun intended)
How long do I have before I am forced to cover my
position? Is there any regulation? Is it simply
dependent on when/if the broker needs them? Could I
possibly stay short for an indefinite period?
As far as I know, there is no pre-determined limit to
how long you can keep your short position open.
Technically, you could be forced to cover at any time,
but typically, having the shares you have borrowed
called back is unusual.
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... back and forth... I made a whole $20.00... Hehe... So tomorow I go for it with a 100 thousand shares... wish me luck!
