Shorting Stocks - For Experienced Traders Only

Recently, I've noticed an increase in posts on the topic of shorting stocks in the Personal Finance blogosphere. Since I have had some experience shorting stocks, I thought I would contribute my point of view to this discussion. For reference, I have shorted nine stocks from late 2002 to mid 2004. My results have been mixed. Seven times I profited from the short trades and twice I lost money. I have not shorted any stocks since 2004.

As a start, here are some definitions. Going short means selling a stock and then buying it back in the future, hopefully for a lower price. If the stock should go down, one makes a profit. If the stock rises, one loses money. This is the opposite of going long, which means buying a stock and selling in the future, hopefully for a higher price.

Short sellers benefit when the stock or the stock market is declining. Because their investing approach requires a stock to do poorly, short sellers are sometimes looked upon with disdain. Objectively, a short seller is someone who is trying to capitalize on a downward direction of a stock or the market.

Short selling is not for the faint of heart, low capital, low expertise investor. It is definitely is not for a novice investor. In my opinion, a short seller should have shown some success at short term trading, have sufficient capital to handle paper losses, and have demonstrated success at minimizing losses. In addition, a short seller should have above average analytical skills to make "objective" decisions.

Here are some more details on the criteria I think an investor should meet before shorting stocks. As an example, I will use Amazon (AMZN) which has 13.2% of its shares shorted. For reference, that is a fairly high percentage of shares being shorted, meaning that these people believe AMZN will have a lower price in the future. Here are the criteria and details:

Demonstrated success at market timing. Success in shorting is not only about being right, but being right fairly quickly. Otherwise, it can be awfully painful waiting to be right. For example, Amazon (AMZN) rose from 44.75 on April 24, 2007 to 62.60 on April 27, 2007. I recall some bloggers commenting that AMZN couldn't support such a high price. Today, AMZN closed at 73.45 after reaching a high of 88.80 on July 25, 2007. If one had shorted the stock on April 27, it would have a loss of $10.85 per share as of today. On July 25, the loss would have been as high as $26.20 per share. On the other hand, if one had shorted on July 25, the gain would be $15.35 per share.

Sufficient reserves to cover short term paper losses. Regulation T requires an initial margin requirement of 50% of the short sale and the NYSE and NASD have a maintenance requirement of 25% of the short sale value. For a short of AMZN at $62.60, one would need to have an additional $31.30 (50%) in cash available in the account, for a total margin value of $93.90. When the stock was $88.80, one would have to have an additional 22.40 (25%) in cash for a total margin value of $111.40. In this case, your broker would issue a margin call for the difference of $111.40 - $93.90 = $17.30 per share. In other words one would need to add $17.30 per share to the account or your broker will close the position.

Know when to close positions. Although knowing when to close a position and taking a loss is important in both long and short investing, it is more important when shorting. In a long position, the maximum loss is the price of the stock. In a short position, the loss can be one, two, three times or more the price of the stock. Also, often a decline in a stock is a short term dip. Waiting too long will cause one's profits to disappear. Finally, as described in the reserves section above, one often needs to add money to an account should the short position begin to lose money.

In addition, it doesn't hurt to have an analytical system for deciding when to short and when to close the position. Often stocks that are shorted can have high volatility with price swings of around 10% or more in one day. High volatility can cause emotional instead of rational decisions. An analytical system can help mitigate emotional reactions.

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This is not financial or investing advice. Please consult a professional advisor.

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