Taking It In The Shorts

With the market finally taking a breather from its seemingly endless downward spiral (6 weeks and counting), some investors may want to try something new, something like "shorting" a stock. Many have heard about this worthy effort, but few know the details on what it really means. The first thing it means is that you can lose an infinite (truly infinite) amount of money. So tread cautiously.

Shorting a stock is simple. You sell one you don't own. If it goes down in price, you buy it back and make money. For example, you sell Ford (F) at $15 and buy it back at $10. You make $5 a share or 33% on your short but 66% on your margin deposit if it's $7.50 a share. Pretty good. But, as with most things in investing, it isn't that simple. There are rules that go with shorting a stock and also expenses.

The first rule is that the stock has to be sold on an uptick. That means, you can't just go in and hit the bid and sell the stock. If you could do that, you could short it continuously until you drive it to almost zero, then buy it back and make a lot of money. So the stock has to trade up before it can be sold short.

Let's say you've shorted your stock successfully. That means your brokerage firm has borrowed the stock from some other account (because there is a real buyer on the other side of the short) and delivered the stock to the new owner. Not all stocks can be shorted. Your broker will let you know immediately when you place the order if the stock you want to short can't be.

Now there are three people involved in the short: you, the new owner, and the account that loaned the stock to the new buyer. This is important because the account from which the stock is borrowed can play an important role in your making or losing money. More on that below.

In your account, you will have a small minus sign by the stock you shorted, meaning that you are short that position. It will also be in a margin account which is the only kind of account in which you can short. There will be a credit balance (if you sold 100 shares of Ford at $15, then it would show $2250 ($1500 plus $750 deposit) if you put up 50% margin which is the norm for a beginning short position, just like a buy in a margin account). That credit balance is real. You received cash from the buyer of the Ford. But here's the catch: the brokerage firm will charge you interest on that credit balance because it's in a margin account. In other words, there is a positive balance in the account, but you still have to pay interest on it.....unless you're a large account that shorts a lot and have a deal with the brokerage firm. Most of us aren't in that league. So that's the first expense: interest on credit balances.

The second surprise comes when the stock pays a dividend, if it does. Since the new owner of the stock needs to receive the dividend, he/she has to get it from somewhere. The old owner of the stock, from which it was borrowed, gets his/her dividend from the company since he/she still shows as the owner of record. So where does the didividend to the new owner come from? Go on, guess......that's right: YOU. You're on the hook for all dividends paid to the new owner. That's more money out of your pocket for having a short.

The next surprise can come from the old owner of the stock. It's called the short squeeze. It works like this. The old owner (and many others) decide they want to sell their stock. But their stock has been borrowed. In order for them to sell the stock, they need it in their account. If their broker can't find another account from which to borrow the stock, the brokerage firm has the right to call back the stock from you. You, of course, don't own the stock. You sold it. So you have to go into the market and buy it back so your brokerage firm can deliver back the stock it borrowed. The timing on this can be excruciating if the stock you shorted has gone up dramatically. Of course, the higher it goes, the more money you lose.

Also, as it goes up, you need to keep adding funds to your margin account because you are losing money, and margin has to be maintained to protect the broker. That's another expensive surprise when shorting.

Another unique attribute to shorting: there are no capital gains. It doesn't matter if you short a stock for a day or for 5 years. If you make or lose money on it, it is treated as short term gains or losses.

Lastly, and this is the most important: you have no limit as to the amount of money you can lose when shorting. A stock can keep going up forever. As long is it does, you lose money. When you buy a stock, it can only go to zero, and you lose all your investment. There is a finite amount of money to lose. Shorting doesn't have that limit. It's limitless in its losses but very finite in its rewards: you can only make, at the most, the difference between where you shorted a stock and zero.

Shorting can be a useful tool. It should be approached with great caution, and any positions taken require the same due diligence as buying a stock. But the consequences of shorting can be much more expensive and shocking than simply buying a stock. If you don't know what you're doing, you can really feel it in the shorts.

- Ted Allrich

June 14, 2011

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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