Here's how it's done. When you ask to sell short, your broker borrows shares for you and sells them (table). The proceeds are deposited in your account. Say you short the stock at $20 and then it drops to $15. You may then buy the shares you sold back at that price--that's "covering your short"--and return them to your broker to repay your loan. Your profit is the $5 difference between the sell price and the buy.
But in practice, shorting is rarely so simple. Suppose the stock you shorted at $20 heads north to $30 or $40 or $60. The more it rises, the more money it will cost to buy back the shares you owe. And consider this: When you buy a stock, the worse case is you lose everything. With short-selling, potential losses are unlimited as stock prices have no ceiling. "You have limited gains and unlimited liability," says Chuck Zender, portfolio manager of the Grizzly Short Fund. "So you must have some method of limiting your risk."
That's why the pros follow strict disciplines. Zender starts covering if a stock rises more than 25% from the price he sold short. Also, if the stock starts rising much faster than the market or its historical pattern, he's out.
Liquidity is also crucial. Many pros avoid very small companies with low trading volume. Why? If you're wrong and the shares start to rise, you may get caught in a "short-squeeze." That's when increased demand for shares pushes the illiquid stock's price up even higher, amplifying your losses. Zender does not short stocks with market capitalizations of less than $1 billion or average daily trading volumes that are less than 6 million shares.
You should also look at a stat known as "short interest," which measures the total amount of shares sold short on a stock. If the short interest is high, a rise in the stock could also create a short squeeze. Ted Kellogg, portfolio manager of the Boston Partners Long/Short Equity Fund, compares the short interest with the average daily trading volume of the stock to see if enough shares trade daily to cover a sudden spurt in demand. If the short interest is more than six times the average volume, he steers clear.
Margin is another consideration. Most brokers require you to have at least 50% of the value of the borrowed shares in cash in your account to establish a short position. And then they'll set a margin maintenance level, upwards of 25% of the borrowed stock's value, to maintain the short. If the stock rises, the amount you've borrowed also increases, and you may experience a margin call, wherein you have to add more cash to the account or the broker will close out your position. Zender recommends putting up 100% of the short's value to insulate yourself from calls.
Not every short position has to be exceptionally risky. Instead of making a speculative bet on a stock falling, you could short sell to hedge existing holdings. This can be useful for tax-adverse investors. For instance, you're worried about shares of a stock that you bought at $10 that now trade for $100. Instead of selling your shares and realizing a large capital gain, you set up a short position in the same stock to hedge against declines. When you think the danger has passed, you can cover your position.
But otherwise, shorting is not for the faint of heart. "Shorting is not something to do unless you have a lot of certainty a company's fundamentals are poor and you can spend a lot of time monitoring its stock," says Kellogg. While many shorts are sitting pretty now, remember that over the long term, markets usually go up. By Lewis Braham