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Short Selling

Of all the investment strategies I have seen discussed, distorted and flat out lied about on the Internet, one takes the cake.

Short selling.

Why? Beats me. If you go long in a stock, you expect the shares to go up. If you go short, you expect them to go down. Either way, you make money if you are right and lose money if you are wrong.

Big deal.

Not to some people. Short selling is a cross between black magic and the annual convention of the Devils Incarnate Incorporated. Short selling is evil, deceitful and, by definition, down right un-American.

Stick your nose in the air and repeat after me: "Of COURSE I would NEVER short a stock!" Harumph, harumph, harumph. How dare you bet on a stock to go down?

I just don’t get it. There are two important differences between going long and going short. Neither one makes much difference if you pay attention to what you are doing – which anyone investing in individual stocks should be doing at least once a week, if not daily.

First, when you go long in a stock, you never have to sell if you don’t want to. Maybe if the company is taken private in a cash buyout (like GEICO), but that’s one of the few exceptions. Keep your shares and give ‘em to the grandkids if that’s your investment goal. No one cares – not the company, the market and probably not even your broker.

When you short a stock, your broker borrows the shares from someone else who has them sitting in a margin account (where most NYSE, AMEX and NASDAQ stocks reside), gives them to you and lets you sell them for the current market price.

Sooner or later you have to return the shares.

"He who sells what isn’t his’n, must buy it back or go to prison." Perhaps the only true cliché there is about shorting.

Let’s take a closer look at the secret inner workings of a short sale.

You decide to short MSFT because you think it’s overvalued in today’s market. Your broker has thousands of clients with MSFT in their accounts, so he happily grabs the shares you need from someone else’s margin account (who will never know their shares were borrowed) and lets you sell them for the usual commission.

He can also loan you shares from his own inventory if he is a Market Maker in the stock, or ask another broker to loan you the shares.

From that point, you want MSFT to go down. If and when it goes down far enough, you don’t have to track down the person who originally bought the stock you sold short. Just buy back the same number of MSFT shares in the open market, return them to the broker and pocket the difference between where you sold and how much you paid for the shares you returned.

If A is greater than B, you just made money shorting MSFT. Does that sound complicated, deceitful or especially un-American? You just bet that MSFT would go down instead of up. Why should that trade be the preserve of a privileged few?

The second important difference is that stocks can go up a lot further than they can go down. It doesn’t matter if a stock costs $10 or $200, it can only drop 100% to zero. Ask someone who has owned MSFT since the 1980’s how far a stock can go up – thousands of percent, doubling and doubling and doubling again.

Some people avoid shorting for precisely that reason. That’s stupid, as far as I am concerned. Any investment you hold should never be allowed to run out of control.

Top traders use a rigid 10% stop loss point, long or short. If the stock goes the wrong way 10%, they are history. Doesn’t matter if good news is coming soon, the market is bound to turn, or any other silly excuses. They sell and move on.

The rest of us tend to have a collection of minus-30% bow-wow’s hanging around our portfolios forlornly trying to look like they will come back to where we bought them one day.

And then there are the minus-50% major league pound puppies. You have to love these creatures a lot to keep on staring at them in your portfolio. But maybe you hang on if you reckon the stock has hit the absolute bottom.

Guess what? Shorting stocks is ABSOLUTELY THE SAME as going long. There is no magic rule that says you can’t put a stop order ("buy to cover") on a short position. Make it 10% whenever you short and you could care less how far the stock could go up IN THEORY. Take the 30% losses when you weren’t as strict as you should have been. And don’t let any position go underwater 50% unless you have very deep pockets.

Most of us don’t have deep pockets, so it’s a dumb idea. If you short a thousand shares of XXYZ at $10 and it runs to $50, you can’t throw up your hands and say "oops!"

You have to replace the stock at your broker and it’s going to cost you $50,000 to do it. It may cost you $100,000 in a week or two. The broker will take your house, your car and the rest of your portfolio if necessary to meet the margin call. That’s the law. So be careful when you short a stock – not paranoid, just prudent.

What if the guy you borrowed the stock from decides to sell in the meantime, before you return the shares he doesn’t know you borrowed in the first place?

Simple. The broker borrows the shares from someone else’s account and moves them around to please all his clients. No one is the wiser. MSFT has billions of shares, so they aren’t hard to find.

Short selling is tricky when there aren’t so many shares "in the float" for individual traders to buy and sell. Imagine a stock that went on a mad tear to more than $70 when they announced they would sell music over the Internet. That stock ’s float at the time would be around 1 million shares. Daytraders bought and sold as fast as they could, driving up the price in leaps and bounds as the Market Makers (who actually execute NASDAQ trades) kept raising the price to encourage sellers and discourage new buyers.

Imagine you shorted the stock at $15 and you saw the price running to $20 then $25 and beyond. What did you do? If you didn’t have a stop loss order in place, you started to panic. You realized you couldn’t withstand a loss much larger than the stock hitting $30 (your broker will insist you deposit more cash in your account to cover the paper loss or force you to cover your short right away – a "short" margin call).

So you called your broker or went online and told the broker to "cover" your position – buy back the stock – at the market price. Problem is, hundreds of other geniuses had the same idea at the same time. Pour that fuel on a fire that daytraders already started and you have LIFTOFF. Everyone is buying at any price they can get. Seventy bucks for a stock that was only $5 a few days before.

Houston, we have a problem.

That’s what they call a "short squeeze." Believe me, you don’t want to be on the wrong end of one. You can lose a lot of money in a hurry just because you were sure the company was rotten and had to collapse eventually.

Your broker can also force you to buy back shares and cover your short if he can’t replace the other client’s shares anywhere else. But that is a rare occurrence in my experience.

Most rotten companies do fall apart once the squeeze fades away. You don’t get a refund if the stock you shorted and covered at a big loss comes down later. You just get to feel like a schmuck.

My advice to newbies is never short any stock with a float under 5 million shares and preferably not under 10 million shares, unless you watch the market all day or your broker lets you put in a stop.

Also look in the Yahoo Profile and check the "short interest" that tells you how many shares have already been shorted. If it’s more than 50% of the current float, be careful. (And don’t forget that the short interest data only comes out once a month so it may be off by a mile two weeks later.)

Often you can’t borrow stock to short when the company’s float is small anyway. All the available stock has already been borrowed and shorted. Most brokers won’t let you short Bulletin Board stocks (OTC:BB) because they aren’t marginable in the first place. Same with most stocks under $5. And IPO’s usually aren’t marginable for 30 days after they start to trade.

Sometimes the rules protect you from your own worst instincts. That’s the idea.

Why does anyone go through the hassle and take the risk of going short in the first place?

Lots of reasons. Many professional shorters (yes, they exist) have told me that finding rotten companies they believe will go down is easier than spotting companies that will go up. Is the latest broadband networking company going to run from $25 to $100 this year? Hard to say. Maybe.

Were Y2K companies like Zitel destined to collapse when it became clear that they weren’t going to make billions fixing other companies’ computers?

You bet they were. And shorts made a bundle. They saw it coming in 1997. Zitel reached $60 one day in late 1996 and now is non-existant. Most "pure Y2K plays" followed suit.

Time to dispel another myth. Contrary to what you hear from some fanatical longs, most shorters aren’t evil conspirators out to undermine wonderful, decent young companies trying to prosper in the great free market called America. Great young companies will do well regardless what shorters do or say. They may even bankrupt a few in the process.

The best shorters happen to have a great nose for sniffing out crap. And they like making money in the process.

The popular delusion says that shorts band together like a pack of wolves and pick an innocent victim to hound to death. They short the stock, bash the company on public discussion threads, scare some longs into selling their shares and profit from the drop in share price. They cover their short positions buying shares that poor longs are dumping at a loss.

The reality is that the shorts take the hindmost. They go after weak, crappy companies with crazy schemes and weak financing. In fact, they serve a public purpose by helping the market to cull out companies that often shouldn’t be trading on the NASDAQ anyway. The Bre-X fraud is a classic example. There are hundreds of others. Sometimes a company just goes up too far and fast. Shorts are selling shares all the way up sometimes, until it comes back to earth.

Zitel never signed more than a handful of contracts for Y2k code remediation. They certainly never generated enough business to justify their market cap. But they kept selling shares to raise new financing, and diluting their long shareholders in the process. The short sellers helped to deep-six Zitel in the stock market the same way that the software market destroyed Zitel’s meager revenue stream. They couldn’t compete so they lost.

Short sellers tend to be fanatics about Due Diligence (DD). They spend hours reading through SEC filings to see if a company’s balance sheet really matches the glossy press release the company just put out.

Hmmmm, sales were up but so are accounts receivable. Will the company have cash flow problems soon? Will those contracts they just signed really generate profits or was the company just stuffing the distribution channels to puff up their earnings numbers? Is their main customer actually a front company that belongs to the CEO’s cousin?

Do yourself a favor and don’t dismiss shorters as soon as you hear them criticizing your favorite company. They may be wrong, but they may be right. And they are out there trading the stock just like you. Only they are already selling while you are still long. That affects your investment.

Forget about the myth that "the shorts are just trying to drive the price down so they can buy shares cheap!" Never happens.

Shorts may "box" their position (go long at the same time they hold a short to achieve a market neutral position during a runup) but I have never met one that shorted a stock on the way down and then said, "Eureka, now I can go long!" when the price hit single digits. That’s just dumb. They shorted the stock in the first place because they thought it was crap.

Shorters don’t pick their targets by accident. If a famous short name shows up on your favorite discussion thread you should really think twice about staying in. They are betting it will go down, and they are usually right. (Stocks with a high short interest statistically underperform their less-maligned brethren on the exchanges).

The market has a simple solution for shorts that are wrong. They lose so much money they have to quit. A long portfolio can lose 20% per year for a long time if you do the math. A careless short will get burned for a few 50-100% losses and have to give up. It’s a tough way to make a living full-time. Only a few do it right and do it well.

Shorting serves another important purpose for the small investor – hedging your long positions. You don’t have to lose billions of dollars running a "hedge fund" to hedge your portfolio. Balance the risk by holding some shorts along with your long positions.

Say you bought the hot tech stocks this year and now you have a big FAT gain in your portfolio. You are afraid the market will crash this fall. But you don’t want to sell in case you are wrong. And you would have to pay short-term capital gains taxes regardless.

What can you do? If you haven’t used the margin in your account, you can "box" your positions by going short an equal amount of all the stocks you own. Don’t sell them outright; sell them short.

You will end up with 50% net equity in your account after you borrow all that stock. Your portfolio balance won’t move at all. If the stocks go up your longs are worth more and your shorts are worth less, and vice versa.

Most people don’t box large parts of their portfolio. Instead they will go long a stock they like (MSFT) and short a similar software stock they don’t like (Zitel). Go long INTC and short their nearest competitor, AMD. Of course, you aren’t "market neutral" then if INTC drops and AMD goes up. Your risk level is double, just as it would be any time you hold twice as large a position long or short.

Better yet, short one of the market indexes or tracking stocks that resembles your long portfolio. The XLK tracking stock is a virtual mirror of big cap tech stocks. The QQQ mirrors the NASDAQ 100.

Lock in your gains without taking a tax hit – by shorting a comparable security elsewhere.

How much you short depends on what you expect from the market. I usually stay 10-20% short (as a percentage of my long positions) but I will go up to 70-80% if I expect a serious pullback. Whatever you choose, you don’t have to be at the mercy of a wavering bull market. Cover your butt where you can.

But don’t short a company just because you think it’s overvalued. Lots of folks did that with Internet stocks in 1997 and had their head handed to them on a platter. Hang around some short threads, see which companies the big short names are targeting and try to tag along until you are confident enough to find some companies to short on your own.

And let’s be careful out there – long or short.