Saturday, November 29, 2008

Selling Short

I hope everyone had an enjoyable Thanksgiving. I know these can be difficult times but Thanksgiving is a time to reawaken thoughts of those things that are positive in our lives and perhaps change our focus away from the negatives.

In the past couple of weeks, some subscribers have written and asked about shorting stock. The markets are currently dealing with levels of support that go back to 2003 and 2004 and we don't yet know whether we are going to see another downward move or whether the bottom has been hit. In any event, it is good to be aware of ways in which a trader might profit in a down market even if it is too late to do so in the current conditions.

Buy stock low and sell high is a common way investors see the way to profits in the markets but that is only possible when the market is moving up. What can be done to garner profits when the markets are falling as has been the case in recent times? There are a variety of ways to make money in a down market, many of which I detail in my first book, "Trade Your Way to Wealth." One of those ways is to sell short.

Short selling is the same as buy low and sell high except it is done in reverse. First, we sell the stock at a high price and later we buy it at a lower price. The difference, less commissions, is our profit. The first question that usually is asked by investors who are unfamiliar with the strategy is how can I sell something I don't own? The answer is that we borrow the stock from our broker and sell it on the open market. That brings cash into our account. Since we have borrowed the stock, from the beginning, we know that we are going to have to replace it and that means that at some time we will have to buy the stock on the open market to cover the short position. That is known as buying to cover.

An example may be helpful. Suppose we see that the markets are falling and the chip sector is particularly weak. One of the stocks in that sector, XYZ has recently come down after hitting a resistance and is trading at $60 a share. We can see that there is a support around $50 a share so we decide to sell the stock short. First we check to see that the stock is available to borrow from our broker and, if so, we sell it short at $60 a share. Suppose we sell short 100 shares at $60. That means $6,000 will come into our account at settlement. Now the stock goes the way we thought it would and begins to fall in price. It hits the $50 mark and we buy the stock to cover our position. That will cost us $5,000, but the market paid us $6,000 in the first place so we make $1,000 (less commissions for the two transactions) on the downward move.

It is important to realize that selling short can entail very high risk. If we are wrong on the direction, we are still going to have to buy to cover the position at some time. Suppose we sell XYZ short at the same $60 a share and then the company announces some new mega-chip and the stock price takes off and gaps up to $70 a share. Now, we would have to pay $7,000 to buy to cover our 100 share short position and would lose $1,000 plus commissions. Theoretically, the upside is unlimited and the stock could go to $100 or $300 a share so great care must be taken to assure that we have an exit strategy in place before we ever initiate the short sale.

Since we have borrowed someone's stock to sell it short, we should also be aware that they would be entitled to dividends if any are declared and since we have sold their stock, we are responsible for those dividends.

As I mentioned earlier, selling stock short is just one of many ways to profit in a downward move. The trader would be well advised to read and learn other strategies as well so that he can determine what is most suitable for his own situation. In "Trade Your Way to Wealth," for example, I discuss at least 5 distinct strategies, including short sales, that a trader can use to profit in a downward move. In Appendix D, I summarize those along with bullish and neutral strategies to illustrate a number of things such as relative risk, capital required, time frame, whether protection is provided, and the level of monitoring that may be required. Knowledge, as is generally the case, is key to success.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved

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Walter said...

"It is important to realize that selling short can entail very high risk."

True, but in reality I do not believe the risk is any greater than going long. It is just as likely for a news item to come out that will cause a stock to make a huge gap down. I have seen a stock I held that was moving up, turn and drop 15% in a day on bad news. Unfortunately, on a day when I wasn't able to monitor my positions.

Unless you are psychic there is no way to mitigate against sharp moves resulting from the news. The only way to cushion against the risk is to stay alert and react quickly to sudden changes. That doesn't prevent the damage, but it will limit it.

Gemma Star said...

While I'm a short-selling scardy-cat, Bill, I am always happy to read your comments. Indeed, I look foward to your weekly e-mail. Your writing is clear and every one of your posts offers thoughtful, helpful advice.

I heard your presentation in New York last February. For those who haven't ever heard you in person, let me tell the world: you are just as clear, thoughtful and helpful in person as you are in your blog.

During this holiday season of thanks and gratitude, let me pause to say: thank you Bill! I'm grateful for your blog and appreciate the fact that you take the time to create it for us. After all, instead of writing you could be....


All the best,

~ GemmaStar

Anonymous said...

Many beginners hoping to learn how to trade and invest in stocks, bonds, options, futures, etc., wonder, and praise, the "gurus" for their free advice and generous blogs. Not to be a cinic, rather a realist, please recognize, these blogs are soley published to drum up business for their paid advisory trading subscriptions, books, seminars or a variety of other sales pitches. Although there are often some merits to what they say, they are not written with YOUR best interests, rather the authors bussiness interests. Always be careful and cautious over ANY single persons opinions and questions their motives. Good Luck!

stratcat2005 said...

I understand the concept of shorting a stock. Borrow and sell to open, buy them back to close. What escapes me is this: Is there a time frame that you have to close the trade in? Obviously, when you trade options you have to buy the shares back to close the trade at expiration. How about the equities?

Walter said...

When shorting you can keep the position open as long as you desire--provided your broker has shares to lend. If the trader who you borrowed from sells his stock, it is possible that your broker will no longer have shares for you to borrow. In that event you would be forced to cover immediately.

Bill Kraft, said...

Thank you, Gemma Star. There's nothing wrong with being a "scardy-cat" with any strategy. If it doesn't fit your trading personality, it is probably wise to stay away from it. You might try paper trading just to make sure you understand any given strategy before putting real money on the line. I don't mean to suggest that real money is going to be the same; it isn't because the paper trades are not accompanied by the same emotion, but paper trading does help us understand the nuances of a strategy. I hope your holidays are filled with joy.
Bill Kraft

Bill Kraft, said...

Thanks for writing, Walter. The risk in going short definitely is greater than going long though the risk in either direction is high. A short theoretically, at least, has unlimited risk to the upside while the risk in a long is limited to what you pay for the stock. There are ways to mitigate against sharp moves without being psychic. With a long, for example, one can buy protective puts as I wrote a week or so ago. A similar strategy is available for the short. Setting stops is another way to help defray losses though in the case of a gap down, may not do as well as the trader may have desired.
Bill Kraft

Elissa said...

Dear Bill: I am not a beginning trader, but I just want to tell you that Trading Your Way To Wealth is one of the best investment books I read this year! I think you have done a great job explaining the importance of hedging, and how to make money no matter what the market is doing. I just want to make one comment on today's article: When you are shorting stock, I believe it is important to buy a call to hedge against the possibility of a move up.

Now Bill, here is my question for you: If the call option is too expensive as a hedge, would you say the market is telling you something about the possibility of a move higher? I would really appreciate an answer to this question. I ask it specifically relative to a "mover" like Apple- lost $100+ per share since its high, yet can make a ten dollar move in a day. Please, advise. And thanks!

Bill Kraft, said...

Stratcat, one thing you mentioned was that when one trades options he has to "buy the shares back to close the trade at expiration." It sounds like you may be laboring under a misconception. If you have sold options and have a short position, you only have to buy them back if you do not want to be assigned and they are in the money. There will be no assignment on an out of the money option, so there is no need to buy to close an out of the money short option position. If the position is at or near the money and the trader does not want to be assigned, he would probably close the position to avoid the possibility. I let many short option positions expire over the course of a year.
Bill Kraft

Bill Kraft, said...

Hi Elissa, and thank you for your kind comments about "Trade Your Way to Wealth." You ask about the meaning when a call is "too expensive" to buy as a hedge against a short position. First I should note that what is too expensive for one trader may not be for another. When calls and puts are particularly expensive as they have been recently, it is a sign of high volatility. When volatility is high, option sellers will demand more premium because they are taking on added risk. As long as the volatility remains high, the options will remain relatively expensive though we can expect the time value to decrease as time passes. Once volatility drops, however, the premiums of both puts and calls can be expected to drop. At times of high volatility, particularly where the implied volatility is higher than the statistical volatility, I like to look for situations where I can sell premium.
Bill Kraft