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SHORT SELLING A current subscriber (J.E.) commented to me that I often recommended shorting and that he wanted to understand this practice better. J.E., if I were a disc jockey, then I'd dedicate this column specifically to you. Many investors are uncomfortable with the idea of shorting, and this lack of ease often carries over to swing traders as well. Yet in order to become a successful swing trader, you need to be able to short as easily as you buy long. In particular, in a bear market when the overall direction of stocks is down, shorting is vital. And even in a choppy, sideways market like the one we are in now, shorting is also a key way to make money. Even when the bull returns, there will be some periods where the market is so overbought that it will be wise to be short. So, what is shorting? Like put options, which I explained last week, the key concept to remember is that if you short a stock and it goes down, then you will make money. If you short a stock and it goes up, then you will lose money. When you short a stock, you borrow the shares temporarily from your broker and sell them immediately in the open market with the intent of repurchasing those same shares in the future at a lower price and then returning them to your broker. On some brokerage screens, in fact, your short position will be shown as a minus. (If you shorted 100 shares if OVTI, for instance, then your account might show you as having a "minus 100" position in these shares.) So, let's say you short OVTI at $24.00, which means you would have brought in $2,400.00 from your initial short position. Let's imagine that OVTI does decline and at $20.00 you decide to terminate the position, or "cover" your short. You now buy the borrowed stock back and pay $2,000 to do so. The balance, or $400, is the profit you'll make on the trade. Of course, if OVTI had gone up to $28, then you would have lost, not made, $400. In order for you to short a stock, your broker must have the shares in its inventory. This typically means you can only short fairly liquid stocks. Regulations often prohibit the shorting of very low-priced stocks under a few dollars a share. Often brokers will publish a list of stocks they will typically carry inventory in and which are therefore shortable. Why do traders avoid shorting? First, it is counter-intuitive. Most people are taught to "look on the bright side of things" and do not consider making money from a declining market. Second, shorting is sometimes seen as unpatriotic. I will admit that after September 11th I refused to short or to buy put options. My reasoning was that when I have a position in the market, I "root" for my position to succeed, much like I root for a sports team. After the attack on the twin towers, I did not want to be cheering for destruction and so avoided shorting. Over the past several months, however, I have again been shorting in my own account. Finally, when you are long, your losses are limited to your initial investment. After all, no stock can fall below zero. Yet when you are short, however, theoretically your potential losses are infinite. If you get caught in a "short squeeze," then you are in for a lot of pain. To see whether the stock you are considering shorting is already heavily shorted, go to Yahoo Finance. Under the stock's "Profile" you will find information on the % of stock that is held short. If the percentage is greater than about 10% of the float, then a lot of people have the same idea as you. Shorting is really very straightforward. After the first one or two times you go short, it should feel just as comfortable as going long. And that, J.E., is the long and short of it. |
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