Short Selling: Sexy or Dangerous?

Investing Advice

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One of the unrecognized dangers in the market is found in the attraction of exotic or complex strategies. Newcomers may find themselves drawn to complex (and risky) investments or investing strategies, when in fact they are better suited to the more “vanilla” ideas like buying stocks in strong companies or mutual funds, reinvesting dividends, and holding onto those shares.

One of those risky strategies most new investors should avoid is short selling.

The traditional buy-hold-sell is flipped in a short sell. In this strategy, investors borrow stock from their broker and pay interest on the value of that stock. They then sell shares, opening up a short position. Hopefully, the share price will fall so that the short position can be closed for less cost, with the difference creating a profit. The risk enters the picture if share value rises. In that case, two consequences come up:

1. The broker demands more money.

Brokers require everyone to maintain a minimum margin balance, usually 50% of positions. So if 100 shares of stock are sold short at $50 per share (remember, that $5,000 was borrowed), you have to keep margin of at least $2,500 on hand. But if share price rises to $60, you need to increase cash or securities to $3,000 to maintain the 50% minimum.

2. You eventually have to “cover” your short.

The term cover means entering a “buy to close” order, cancelling the position. If the share price has risen above the original price upon sale, the difference is a net loss. So your overall loss is the combination of the loss on the short sell and the interest you had to pay your brokerage for loaning the stock to you.

If you do decide to engage in short selling, it’s worth remembering a few basic risk-related rules.

First, never sell a stock short until you understand the risks involved. If a stock is over-valued today, it is possible that it will be over-valued even more next month. You cannot rely on timely adjustments by the market under any circumstances. An over-valued stock does not remove the risk of further price inflation. For most investors and traders, short selling is too risky and too expensive.

There are alternatives. In some situations, when one sector is likely to rise in value, another may be equally likely to fall. This is due to the cyclical nature of sectors and how they interact with one another. Identifying sectors at the bottom of their business cycle may also point to good buying opportunities. It is safer to time long positions and enter the market at the bottom, than to try and time short sales at the cyclical top.

Another alternative is to avoid short selling altogether. If you believe a stock’s price is due for a serious downward correction, you can enter a very low-risk strategy, buying put options. A put’s intrinsic value increases for each point the stock falls. So rather than selling stock and risking a large exposure with borrowed money, you can buy a put for about 5% of the cost of 100 shares. If your timing is wrong, that is all you stand to lose. If your timing is right, you can realize a spectacular profit.

The bottom line of shorting stock is clear: For most investors, it is simply too high-risk and, more to the point, unnecessary to make a bear play in the market. If you want to speculate on the timing of price movement, focus on long puts: they are cheaper and safer than shorting stock.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

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