Understanding Short Selling
Stockscores.com Perspectives for the week ending August 12, 2007
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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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I think the markets have good potential to bounce back early next week after some selling pressure last week. US markets started Friday very weak but came back to close strong as the Dow and Nasdaq bounced off of support.
With that in mind I thought I would run the Pull Back Plays Market Scan on the Nasdaq market. This strategy seeks strong stocks that have suffered some short term weakness but appear to be bouncing off of the upward trend line. With that scan, I found a few stocks that may be good swing trading set ups that should have a few days of strength if the market can bounce as I think it will.
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1. TUNE
closed strong on Friday after a few days of weakness, it looks like the upward trend can continue provided short term support at $5.20 is not broken.
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2. ALVR
this stock has been very volatile of late so the probability of success is not as good with the swing trade but the risk reward potential makes it worth considering. Needs to close above support at $10.70 to stay in play for this strategy.
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3. CRNT
the stock has backed up right to the trend line and bounced off of it on Friday. I would watch the intraday on this one for a confirmation signal becaues the stock could still see more profit taking. However, if it does bounce it should be a strong one. Support at $13.
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References
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See which sectors are leading the market, and their components.
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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