Short Selling Basics
Stockscores.com Perspectives for the week ending August 11, 2006
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In this week's issue:
You can buy a stock or you can sell it. For most investors, the buying usually comes first. We buy a stock in anticipation of it going up, so that we can sell it at a profit.
It is also possible to sell the stock first. Sell the stock with the expectation that it is destined to go lower, so that we can buy it back cheaper in the future. This simple reversal of the process is called shorting. Successful investors utilize this strategy, taking advantage of the simple fact that stocks do not always go up. However, there are a few different rules that investors need to be aware of when shorting stocks.
The most important thing to realize is that, when you short a stock, you have to borrow it from your brokerage house. To do that, your brokerage house has to have the stock to lend. If you short a stock, the brokerage house will actually deliver the shares to the new owner by using shares that another of their customers own. The idea is that they will replace the borrowed shares when you buy them back, effectively covering your short.
The ramification of this is that you can not short any stock that you want as the brokerage house has to have the stock in inventory. Generally speaking, stocks that have good liquidity (trade at least 100 time a day) have a wide enough circulation that your brokerage house will allow you to short the stock. However, an added risk of shorting is that the brokerage house could order you to buy the stock back if they are unable to cover the borrowed shares. That order to buy back can come any time and may come at a time when you are forced to take a loss.
Another important consideration is that there is no limit to how high a stock can go. When you buy a stock, the maximum amount you can lose is your investment. However, when you short a stock, the potential loss has no limit because the stock could keep going higher and higher. It is for this reason that many people consider shorting too risky. My opinion is that buying or shorting are both risky if the individual doing it lacks discipline to limit losses. For the disciplined and experienced investor, shorting can be worth the extra risk.
Because of this added risk, many brokerage houses will not allow you to short stocks that are under $3. Their concern is that cheap stocks are at risk to show more volatility and could go dramatically higher, effectively wiping out a lot of a client's equity.
The added risk of shorting also requires that the client maintain more money in their account than is necessary to buy the stock back. This extra amount is referred to as margin. Generally, brokerage houses require 150% of the market price of the stock that is shorted. So, if you short sold 1000 shares of a $10 stock, you should have $15,000 in your account. Remember, of course, that when you short sold the 1000 shares you put $10,000 in your account. So, you really only put up $5000 in equity. But, if the stock goes up, you may be required to add more equity to your account to ensure that the 150% requirement is kept.
Having the option of shorting open to you is liberating, as it no longer forces you to only buy stocks that you think is going to go up. A psychological hurdle for investors is "hoping" a stock will go higher instead of heeding the truth, which often says the opposite. When an investor can make money on either side of the market, he or she is likely to make better judgments.
Another advantage of shorting is that stocks tend to move down more quickly than they move up. Perhaps this is because fear is a more powerful emotion than greed. Those proficient at anticipating stocks that are destined to go lower are often rewarded with shorter hold periods, and therefore, lower opportunity costs.
The key to taking advantage of the shorting mechanism, of course, is in knowing how to find shorting opportunities. Visit the Selling Strategy area of Stockscores.com for some ideas.
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For this week's strategy I did something quite simple. I set up the Market Scan to look for stocks having an abnormal day to the upside with abnormal volume and set a minimum number of trades for the scan at 100. I then looked through the charts to see if there were any patterns that I liked.Back To Top
1. GROW
GROW was the only stock that stood out. I like it because it shows a break to the upside from a falling wedge pattern. I would estimate that this pattern has about a 65% chance of seeing the stock move back to resistance at $28 and a 35% chance of getting stopped out at support of $18.95. With the Friday close of $21.58, that gives an upside of $6.42 and a downside of $2.63 for an expected value of the trade of $3.25 or about 15%.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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