TheStockAdvisor Advice

Short-Selling - "Don’t Just Say 'I Told You So!', Make Some Money!" ?

Your friends, co-workers and now even your wife are all talking up the latest hot-stock. They all know someone who just "made a million" on this sure thing. The stock has just doubled in price. In a mere month it climbed from $35 a share to $70. But, its going further they say. The common refrain is, "it’s going to be at $100 by year end."

You’re not one to blindly jump on anyone’s bandwagon, so you check out this "sure thing." Your research discovers that the company is indeed working on a promising new product. But you also are convinced that even if they bring it to market tomorrow and sell twice as many as your friends promise will be sold within the first year, there is absolutely no possibility for them to earn enough to warrant a $70 share price, let alone justify another move to $100.

What are you to do. Of course, you can sit back, do nothing and hope that in a few weeks you can tell your friends, (but especially your wife) "I told you so. Good thing I didn’t put our life savings into that bit of hype."

But there is an alternative that will allow not only the feeling of being vindicated, but to do one better, profit from what you are convinced is the inevitable end-result of your friends avarice. This is accomplished by a strategy known as short selling.

Short selling is an investment approach that involves the selling of a security with the intention of buying it back at a later date at a price below that at which you already sold. As with any transaction, the profit is the difference between the purchase and sales prices. Except that in a short sale the order is reversed. The sale price is locked in first and the purchase price is established when the stock is bought, hopefully at a price well below where it had been sold.

As with any foray into the equity markets, this strategy is not without risk. If your research was faulty and the company actually sells three times as many units as had been expected and makes profits well in excess of forecast, you may actually be looking at a $120 a share security. Had you sold this stock short at $70, you should have had a stop-loss order in place to buy the stock back below the $80 level.

But we want to be positive, at least as far as your profits are concerned. So we will assume your analysis is correct and the shares do head south. One of the first requirements is to define a price objective. There is a drawback with short selling inasmuch as the maximum movement is from the sale price, down to zero. Now let us assume this company is not going out of business so zero is not a logical price objective.

Each situation is different, and setting a price objective will depend upon the individual circumstance. The important point to keep in mind is that the objective be realistic. In the case we have created for this illustration, a logical starting point might well be the price of stock before all the rumors or hype surfaced. If the new product does indeed exist, but the growth projections are unrealistic, then the target price will have to be very carefully defined.

As the price of the stock declines, make sure to have stop loss orders in place above the current trading price to assure of not losing your gains if the shares suddenly reverse trend and go back up.

Do not wait for the last 1/8 point to materialize when finally buying back the shares, even if your analysis, knowledge or "gut feeling" are proving correct.

When one sells short, it is important to keep in mind that your broker has to borrow securities for you to deliver to the purchaser. The investor who buys the share from you under the short-sale, is not interested in how they come to him. He just knows he bought shares and he is entitled to them.

Your broker will borrow the shares for you, but you will be charged a monthly fees as long as your short-sale is not covered. These fees will be calculated on a monthly basis.

Before getting involved in short-selling you should discuss this with your broker and find out exactly what his fees are and how much interest you will have to pay for the borrowed paper. Procedures and financial requirements vary from one firm to another so it is best to be aware of your firm’s policies ahead of time. Remember forewarned is forearmed.

One should also be aware that the New York Stock Exchange, The American Stock Exchange and the NASDAQ issue monthly short-interest report for all the stocks on the exchange that are subject to some short selling. This list can held provide information as to how many other shareholders are doing a similar strategy. The reports also list the number of shares that have been sold short, which could help in developing some strategies.


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