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Should You Short Stocks?

Posted on Monday, March 7th, 2011 at 6:19 pm (9) comments

By: slickdealer dittyesq

Image by Flickr user Mike Lee

For the past few weeks we’ve been discussing the subject of how to invest — safely — in the stock market. Today we’re going to veer off that path by just a few meters, and briefly address the subject of investing against stocks: Selling stocks short.

The concept of “shorting” works like this, in five easy steps:

1. First, borrow shares from someone who already owns them.
2. Next, sell those shares at $X, and pocket the cash.
3. Now, wait for the price of the shares to decline, and buy them back at a lower price.
4. Replace the shares you borrowed at $X with shares purchased at $less-than-X.
5. Last but not least, “keep the change.” The difference between the price you sold the stocks for, and the price paid to buy them back, is your profit.

Sounds simple, right? Automatic profits. So maybe we should all just give up on this whole “investing” idea and instead take up shorting?

In a word: No. You should not short stocks, and now I’ll tell you why.

“The market can remain irrational longer than you can remain solvent.”
Despite its obvious attractions, people have been writing about the dangers of shorting stocks for nearly a century. This quote, for example, is attributed to the English economist John Maynard Keynes, who warned that even when an asset is obviously overvalued, there’s still a risk to betting its price will fall. Simply put: It costs money to short stocks. It takes time for the strategy to pay off. If you run out of either money or patience before your bet pays off, you can go broke betting that a stock will fall.

Congratulations! You get to pay interest! And dividends!
Here’s how it works. Whenever you short a stock, your broker will charge you “margin interest” on the value of the stock sold short — interest that could cost you as much as 9% annually. Conceivably, you could need a stock to drop 10% (or more) before you see any profit at all from shorting — and it gets worse.

When you sell a stock, cash is deposited in your account. Problem is, your broker will not ordinarily pay you interest on that cash (and even if it did, good luck finding a broker that pays 10% interest on deposits.) Plus, if you happen to have picked as a short target a stock that pays dividends to its owner, guess who gets to pay those dividends to the stock’s original owner?

That’s right — you do. Remember that you borrowed the original owner’s stock, and sold it. The company’s no longer paying dividends to him, because he no longer owns the stock — but he still wants his dividend check every quarter, and you’re on the hook to make sure he gets it, up until the time you close out your short position.

Of course, maybe you’ve got the cash to cover margin interest and pay dividends. Maybe you’ve courage in your convictions, and all the patience in the world, to wait as long as you need to be proven right. Surely money and patience will guarantee you profits … except that they won’t. You can still lose money shorting if just one corporate CEO out there is not as smart as you, doesn’t realize the company you shorted is lousy, and decides to acquire it.

For example, I know a very smart hedge fund manager who once explained to me in very convincing terms why the smartphone company Palm was “going to zero.” The company had little cash on hand, was burning more cash, owed huge obligations to preferred shareholders, and was losing market share. Unfortunately for him, and for many other investors, Hewlett-Packard disagreed about Palm’s prospects, and decided to buy the company for far more than it was “worth.” Result: Instead of going to zero, Palm stock gained more than 20% in a single day. So much for that (short) idea.

Margin calls
Nor are dumb CEOs the only people you need to worry about. You see, smart as you may be, not all investors are geniuses. Eventually, some investor (not you — the other guy) will short a stock only to see it double, triple, then quadruple in price. He’ll be wiped out, as the money he “earned” by selling a stock short gets dwarfed by the amount he must eventually pay to close out his losing bet.

To protect itself against this, brokers require that investors keep a certain amount of cash or securities on hand to cover their losses. 30%, 50% — the amount varies. But the upshot is that if a stock you sell short rises 50% before falling, your broker can require you to put up more cash to protect it against a loss. If you don’t produce, or don’t do so fast enough, your broker can close your short position on its own — cashing you out at a loss.

And that’s the good news
The bad news is that although the above list includes a few of the most dangerous aspects of shorting, it’s far from a comprehensive list. I hope, however, that it’s at least enough to alert you to the fact that shorting does have risks.

But just in case you need one more example, I’ll provide one: On December 5, 2006, then-Fed Chairman Greenspan warned investors that the U.S. stock market was showing signs of “irrational exuberance” and would eventually fall. At the time he wrote those words, the Dow Jones Industrial Average was priced at 6500 and change.

The crash Greenspan predicted did eventually arrive, of course. (In fact, we’ve had multiple crashes since then.) But even the first one took more than four years to arrive.

International lawyer by day and Slickdealer by night, Rich Smith is always on the lookout for a good bargain. Helping corporations pillage Third World economies is great for paying the mortgage, but Rich’s real loves are writing about stock investing for The Motley Fool, buying cheap stocks for his own portfolio, and strolling the aisles at Slickdeals in search of the ultimate blue-light special. A veteran of Moscow, Kiev, and Washington, D.C., Rich has traded-in city life, and now takes his ease in the fields of rural Indiana.