Sell Now, Buy Later - the ABCs of Short Selling

By: Jake Weber | Thu, Apr 15, 2010
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The catch phrases "Buy low, sell high" and "The market fluctuates" are probably the two most frequently used clichés of the investment world. The latter statement is hardly astute, and the former far easier said than done. What both of these simplistic ideas overlook is a third concept largely ignored by the investing public, "Sell now, buy later."

The idea of selling something that you don't yet own is a foreign concept to many. However, in a powerful bear market, it's an important strategy to understand and utilize, though for reasons I'll discuss below, only as a relatively small and closely watched speculative portion of your portfolio. The concept I'm referring to, of course, is short selling.

The basic mechanics of selling short a stock are not complicated, but, as with any investment, there are risks involved, and it requires discipline to execute these trades successfully.

What Is Short Selling?

If, after carefully scrutinizing a security, you conclude that there is nowhere for the stock to go but down and want to put your money where your brain is, there are a couple of different alternatives. One way to go is the options route, selling calls or buying puts on the stock. This is certainly a viable route with plenty of opportunity to profit; however, with options, not only do you have to be right about the direction, you also have to be correct about the timing and strike price.

The other alternative is to open up a margin account and sell the stock short. That requires posting a margin - cash or securities - in your account. With that condition met, your broker will undertake to borrow the stock from someone that owns it. Once your broker has acquired it, either from another client or another brokerage firm, he or she will sell the stock and deposit the proceeds into your account. What you own now is a liability to purchase back, or "cover," those same shares at some point in the future, hopefully at a lower price. Because there's a loan involved with this transaction, you'll be charged an interest rate on the amount borrowed, likely in the area of about 4.5% annualized these days.

With a short sale, your maximum gain is capped at 100%, which you would only collect if the stock goes to zero - but your loss is technically unlimited because stocks have no cap on the upside. Of course, there are ways to limit your losses, which we'll discuss in a moment, but first let's look at what could happen to your account should the stock fall, as you hope it will... or rise, as you hope it won't.

For the purpose of this example, let's say you came to the conclusion that XYZ stock is overvalued at $25 a share and so you sell short 100 shares. Here are the implications of two different scenarios subsequently unfolding:

Table Showing Profit/Loss

Your maximum profit of the XYZ short sale is $2,500, but the sky is the limit for your losses and will be magnified, should you use margin. This potential for open-ended loss is enough to deter most investors from shorting, and is the reason we recommend you do so only with the speculative corner of your portfolio.

Minimizing Risk

Short selling is an aggressive strategy to pursue. There are, however, measures you can take to help mitigate risk.

Limit Your Margin

One of the ways to avoid large losses is by limiting the amount of margin used to borrow the shares. To sell short in the U.S., regulations require that the stock be "marginable," and an initial deposit is required - 50% for stocks above $5 per share and 100% margin for stocks below $5 per share. After you borrow the shares, the rules require you maintain equity in the account worth at least 25% of the total market value of the security.

These are the regulatory minimums; individual brokerages may have additional rules and limitations for margin accounts, so be sure to carefully review your margin agreement. Even so, to avoid being "chased out" of a trade, you may want to deposit more cash than required by your broker in order to further cushion your position.

Keep in mind that the interest paid on the borrowed money will eat into your returns, reducing your potential upside, the longer you hold open a position. Also, any dividends issued while you are borrowing the stocks will be transferred from your account to the original buyer. We highly recommend that you actively monitor your account to avoid any margin calls and minimize your risk by reducing the use of margin.

Use Stop-Loss Orders

If you aren't able to actively manage your investment accounts, then stop-loss orders can help soften the blow if the trade quickly turns against you. When the general market or sector gains upward momentum, even the fundamentally weakest stocks can catch a free ride. In order to limit your loss, consider placing orders to "buy to cover" at a price above your initial short sale price and remember to review your stop-loss orders periodically to assure you are covered.

A Few Key Terms:

Proceed with Caution...

If short selling fits within your scope of risk tolerance, it can be very profitable. Even so, it's important you avoid being overleveraged in any position and never, ever "bet the farm" with a short position. Rather, only invest with money that you can afford to lose and consider using stop-losses.

As Jake says, short-selling can be very lucrative - if you correctly assess the broad market trends. That's what The Casey Report does: analyzing budding trends and finding the best opportunities to profit from them. And as a special Tax Day offer - for 2 days only - you can now get The Casey Report for $150 less... PLUS one free year of our two most popular precious metals and energy advisories. Click here to learn more.



Jake Weber

Author: Jake Weber

Jake Weber
Research Analyst
Casey Research, LLC.

Jake Weber

Jake Weber graduated from Loyola University in New Orleans with a Bachelors degree in business administration with a focus in economics. While in college, he was the bookkeeper for a local restaurant, the director of finance for the Student Government Association, and interned with a commercial real estate research firm in Southwest Florida. In his senior year, Jake caught the attention of the Casey Research team through diligent research and witty articles he contributed to "The Room." In July 2007, he started his position as a full-time research analyst with Casey Research. Jake has recently become the new editor of Casey's Charts and continues to provide research for Casey's Gold & Resource Report and The Casey Report.

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