September 2011

Short Selling: Is Short Selling Worth the Risk?

Author: Robert Star

By now, you have probably decided to ride out the current market volatility or you are ready to sell. We just do not have a clear picture of the future of our economic environment. We know our country has financial problems, the housing and job markets are horrible, and the European Union is not working. So what can an individual investor do to hedge against a down market when investing in publicly traded securities has too much risk associated with staying “long”? Some investors look to sell stocks short, but this can be a tricky game.

When the market is diving, short selling is a tempting option. After all, when even strong stocks are losing value, betting on the decline of a weak stock seems like a sure thing. Short selling is fraught with risk. Markets that seem to have no bottom can turn on a dime, leaving the short seller with enormous losses.

When an investor purchases shares of a stock from a broker, the investor is considered “long” the stock. This means the investor makes money when the stock increases in price and plays to the old rule: buy low and sell high.

Almost every mutual fund or third party asset manager is considered long only. So in times like these, or as in 2008, an investor’s only option in a long only portfolio is to ride out the market’s volatility or sell and go into cash.

On a short sale, it would be just the opposite; investors sell a stock short and are “short” a stock when they believe its price is certain to fall. An investor is actually selling a security that he or she does not own. The investor is borrowing stock from the brokerage firm’s inventory. At some point the investor will close short position by buying back the shares. If the price of the shares drops and investor buys the stock back at a lower price, the investor will make a profit on the difference. This is called covering your short position. There are some other technical nuances with this transaction, but this is the long and short of it, pun intended.

This strategy seems so obvious in a down market. However, there are several reasons short selling is dangerous. If the investor is wrong and the share price rises, the investor must buy the shares back at a higher price, which creates a loss. Because there is theoretically no limit to how high the shares can rise, the potential loss is unlimited. When contrasted with holding long positions, the value of a stock cannot drop below zero, and the risk is limited to the amount of capital invested in the security.

Investors can lose money shorting stocks even when they’re right about the merits of the company. A company can see its price increase because of good news reported by another company in the same industry, because of a general wave of good economic news, or because of other unforeseen factors. This may result in an increase in the share price, with disastrous results for short sellers.

For any reason, when too many investors short the same stock and the short sellers are rushing to cover their shorts, demand for the stock is created. If this scenario is compounded by long investors buying the stock, it might move sharply higher, causing a so-called “short squeeze,” which forces the investors to cover at a much higher price.

Another way to profit if you are certain a company’s price is going down is by buying put options on the company’s shares. Simply stated, put options give you the right to sell a company’s shares at a given strike price, allowing you to pocket the difference between the future, lower price and the strike price (minus the cost of the options, of course.) While you can lose your investment, your loss is limited to the cost of the put options. Because options are only good for a specified length of time, you can still lose, even if you are right about the ultimate fate of the company’s shares. You should therefore limit your use of put options to those situations where you are quite certain a given catalyst for lower share prices will occur within the duration of that time period.

Buying put options or shares in a bear fund or in Exchange Traded Funds (ETF’s) that are short a sector are safer ways to bet against the future of a company, a sector, or the market as a whole. With put options, your potential loss is limited to the cost of the puts. Puts should be purchased only in situations where you are fairly certain that a given price drop will occur within a certain window of time. Keep in mind that bear funds can lose money even if the market drops, depending on how they are managed.

Not everyone is comfortable with options, however. They can be quite confusing and are best avoided by new investors. Short selling is an extremely risky maneuver that can have disastrous consequences for your portfolio. Because loss is potentially unlimited, short selling should be attempted only by very experienced investors with extensive knowledge of a situation. Even then, things can go horribly wrong.

In most circumstances, traditional long positions are the safest way to invest in the stock market. In these difficult times, you should constantly evaluate your positions, your long- and short-term allocations. The main reason people get hurt in this sort of market is that they believe their trusted advisor will contact them if there is something that needs to be done. But a long only strategy can be very expensive, and there is no guarantee the markets will recover. It has been a decade, and the Nasdaq has not recovered from its 2001 losses. Is the Dow Jones or S&P next? The days of buy, hold and hope are long gone. Get active, seek advice, be better diversified, explore alternative assets and get a second opinion on your current investment strategy.

Robert Star is the managing director of EDI Financial Group.

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