Investing Strategy - Part III

Short Selling

Short selling is an interesting strategy to use. Essentially, it takes the idea of buy low-sell high and turns it on its head - sell high-buy low (in that order). It is certainly one of the most risky strategies that you can undertake in the market, as your upside is absolutely limited (the stock can only go to zero), while your risk is absolutely unlimited (just like the stock price itself). So how do you go about short selling and why would you want to do it in the first place?

Most investors are in the market to make money. Period. They don't really care all too much where it comes from so long as it goes into their account. As a consequence, they're constantly on the lookout for something that will allow them to make money in a down market, as well as an up market. Enter short selling.

With short selling, you are actually borrowing the stock from someone else and selling it, with the intention of buying it back at some point for less money than you sold it for. Pretty simple, huh? So why is it so risky?

First of all, you have to be able to borrow the stock, which is not always easy to do. On volatile stocks it is not uncommon for your broker to tell you that the stock isn't available. But that's not so bad. At least at that point you're not into a trade yet.

When you have found stock to borrow, if the original owner decides to sell the stock, your broker will have to work on finding some more shares to cover your position. If the broker cannot find more shares for you, you can get caught in what's known as a short squeeze. If that happens, you end up buying the stock back at the current market price whether the resulting trade is profitable for you or not.

Now even if you find the stock, and you don't get squeezed, you're still not out of the woods yet. In order for this strategy to be successful, the stock must go down in price. If it does not go down, you lose money, and it can go very, very quickly. The worst I ever saw was a fellow who managed to blow his entire account, plus another $250,000 beyond shorting Yahoo! on the way up. It was the only time in my brokerage career that I actually saw a firm take a client to arbitration to try to recover money for losses.

Think about that for a minute. He played the game and lost. He lost everything he had plus a quarter million. Buy a stock; you can never lose more than your original investment. Short a stock; you can lose everything and then some.

And that's not all. Remember, you borrowed the stock. The original owner is expecting to receive all the benefits of ownership. But you sold their stock. How do they continue to get things like dividends or stock splits?

Easy, you pay them. You short the stock, you pay the dividend. If it splits two for one, you get to buy back twice as many shares.

When the risks are acknowledged and understood and proper research has been done, shorting a stock can be a great tool for enhancing your returns in a down market.

The important thing to remember is to beware. Generally the risk is outsized in relation to the potential return. Make absolutely sure that you're comfortable with a short before you enter into it. And if the trade goes bad anyways, don't be afraid to cut your losses.