We all make investments in the stock
market to make money. A common goal of most small cap investors is to purchase a
stock that has not yet reached its full potential, a possible diamond in the
rough. Companies that boast the newest technology or cutting edge products are
usually where we look for the best opportunity. Normally investments are made
based on the belief that something positive is going to take place in the future
that will increase the value of a stock. When we sit back and evaluate the stock
market, it is really nothing more than a forum for legalized betting. Investors
bet that a company is going to increase in value.
In any transaction there are two parties, someone
who believes the company results will be positive and increase in value, and the
another party who believes the performance of a company will diminish and reduce
in value. Investors can choose to take either stand. It is easy to bet on a
company, we simply buy the stock. When investors bet against a
company's success it is called shorting or taking the short position.
The whole concept of shorting stock is confusing
to people because it breaks the forward train of thinking by adding another
dimension to the bet. The normal train of thought would be, "Don't buy
the stock if you think it is not a good investment." But the concept of
shorting gets more detailed in its objective, short sellers are also betting
that they can get the investors who initially bet that the stock would increase
to change their position. This negative volume creates an imbalance in the
market and forces the price of the stock down.
Every year billions of dollars are made and lost
by investors taking a short position. The advantage to short selling is that
investors do not need a lot of capital to make these investments, they open what
is called a "Margin account." A margin account allows investors
to borrow stock from an investor account other then their own. The transaction
takes place in several calculated steps; the stock is borrowed and immediately
sold. The investor is betting that the stock value will decrease allowing them
to buy the stock back at a lower price and return it to its original account.
What most people do not know is that that borrowed stock could be their own!
While you are betting on a company's success, another investor is borrowing
your stock to take a "short position" This has a direct,
negative effect on your investment. Because other investors react to the
negative volume, or the selling, they also sell. If you do not feel like this is
ethical, call your broker and request that they not lend out your stock.
Although the "Short selling" of
stock can be very profitable, there is a negative side. An investor can get into
trouble rather quickly if the stock goes up. Besides having to pay a customary
borrowing fee until the stock is returned, if an investor gets too far behind,
the broker is required by law to make a "Margin call".
When shorting a stock, there are no secrets,
investors must make it clear to their broker that they are shorting a stock.
Investors must also determine a price objective. A price objective is an upward
and downward cap on the movement of a stock. This technique is especially
helpful in the event the stock skyrockets, limiting the amount an investor can
Lets take a look at how the short sellers can
affect the financial progress of a company. CEO's tend to take it personal
when traders who know very little about their company bet that they will
under-perform. The process can create a volatile environment and at times be a
false indicator of poor performance. In conversation with an ex-COO of a NYSE
company he explained, "The adverse symptoms of stock shorting can be
debilitating. Management took it personal!"
For publicly- traded companies it
is important that they constantly sell their concept to investors as a strong
and powerful idea that will eventually air success. Reporting positive news and
motivating investors with positive facts is what helps create an environment
where existing shareholders remain confident and potential investors continue to
It is unfortunate that actual performance may not
always dictate stock price when the stock is being shorted. Firms are required
to report their short positions as of settlement on the 15th of each month. A
compilation is published eight business days after and can be found on www.nasdaq.com.
If you notice a short position is being taken on
a company in your portfolio do not be so fast to throw in the towel. Quitting
too early is what short sellers are betting on. They have created an uneasy
feeling for existing shareholders that will test their loyalty. This possible
misdirection could be a way of luring existing investors down the wrong path
resulting in a loss for those who jump ship. Be confident in your investment and
have up to date knowledge of your companies. There was a reason that you
invested in a particular company before the short existed, those reasons are
probably still strong arguments that the company will continue to operate and be
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