|
|
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:
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:
- Short Interest: This is the aggregate number of short sale
positions on each security. This information is published monthly by the
exchanges and also offered through many other websites such as
Barron’s and Yahoo Finance. It’s important to monitor how
many shares have been borrowed because they will eventually have to be
bought back (see Short Squeeze, below). Generally,
the lower the short interest,
the better.
- Days to Cover: This is another important data point to track,
because it’s an estimate for how many days it will take to unwind
all the outstanding short positions. It’s calculated by dividing
the current short interest by the average daily trading volume of the
stock. The fewer days to cover, the better.
- Short Squeeze: Should a stock appreciate by a substantial
amount, it is entirely to be expected that some number of short-sellers
will decide to cover their short or be forced to it by margin calls. Of
course, that requires closing their positions by buying the stock back,
which gives the stock further upward momentum. This may in turn force
other short-sellers to cover, thus creating a rush to cover known as a
short squeeze. Using stop-loss orders will help prevent getting caught
on the wrong end of a short squeeze.
- Called Away: This refers to being forced to cover your
short position because the lender requires delivery of the stocks. While
this technically could happen at any time, it is exceedingly rare and
would typically occur only if a clearing house couldn’t find shares
to borrow for exchange-traded funds. This is something certainly to be
aware of, but it’s not a cause for great concern, in our opinion.
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.
Jake Weber
|
|
