A Guide to Shorting Stocks

Joel Anderson  |

Investing can’t be all puppies and rainbows.

Stocks go up, and they also go down. Anyone who’s honed their ability to dig into a company’s balance sheet or pour over market data to suss out economic trends has trained themselves to spot those companies that are healthy and represent a solid investment. But that same data might indicate a company is instead heading towards its day of reckoning.

So what happens when you think a stock is going to lose value? One nearly universal truth in the markets is that if you know what’s going to happen before it happens, there’s a way to profit from it. But how do you do that with falling stocks?

The answer is the bear’s best friend: the short, or short-selling. It’s a way to profit from despair, to benefit from others’ tragedy, and a strategy that’s often derided for its cynicism. But, push comes to shove, the practice of observing weakness and profiting from it is as old as the market itself.

The process for shorting a stock can seem more than a little convoluted, but stocks are, by design, a method of investing in a company’s future, so it takes some maneuvering to reverse that purpose.

Say your friend Larry is dead certain he’s sitting pretty with his heavy investment in the darling of the consumer discretionary sector, the Acme Company. You’ve noticed, though, that their products tend not to work as intended and injure their users at an alarming rate. What’s more, you’re pretty sure the upcoming issue of Coyote Digest is going to shed some light on this, causing the stock to plunge. You want to take up a short position.

Basically, you and Larry would come to an agreement where you borrow Larry’s Acme shares and return them at a later date. You then sell Larry’s shares, wait until Coyote Digest runs its hatchet job on Acme’s product catalogue, then buy back the necessary number of shares at their new, much-lower price. You return Larry’s shares, but you’ve made a tidy profit.

This basic structure has many variations, but they all work on the same basic concept: an investment vehicle that functions as an inverse of a stock’s price.

Obviously, any time a stock declines in value, there was an opportunity to profit from a short. But as a tool for investment, shorting has some significant shortfalls.

First, a broad look at the markets should make it clear that stocks, collectively, rise over time (or at least they have to this point). The S&P 500, over the last 50 years, has averaged annualized returns exceeding 10 percent. The big picture for shorting is that, generally speaking, it’s swimming against the current of broader historical trends.

However, the more important consideration is one of liability vs. potential profit.

Best case scenario for a short position? The stock goes to zero and you can double your initial investment. Worst case scenario? A stock takes off, like REALLY takes off, and you end up looking at a short position that can ultimately cost you three or four times your initial investment, if not more. As long as that stock keeps going up, you’re still on the hook, and the potential losses greatly exceed the maximum profit.

This imbalance of potential returns against potential losses that leads to a phenomenon called the “short squeeze.”

If a stock starts to rise sharply, even the most steely-nerved short-sellers have to start second-guessing their bets against that company. And, given that they can potentially lose a lot of money if the stock keeps soaring, they may want to liquidate their position and cut their losses.

And this has a snowball effect. Some shorts start buying up the necessary shares to cover their short positions, buyers create more upward pressure and drive the price up even more, driving out even more short positions, and so on and so forth.

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At the end of the day, even a moderate gain can sometimes pick up momentum if the shorts start abandoning their positions. In fact, some traders with a big investment in a company may start buying shares when they spot upward momentum just to try and push out the shorts and spike share prices. That would be the “squeeze” part.

Of course, there’s another way to bet on a stock falling: options contracts, or deals to buy or sell a stock at a certain price at a time in the future.

Let’s return to Acme. If you’re sure Acme is going to drop, you can just purchase something called a futures contract, which gives you a right to sell shares of Acme at their current price (maybe from Larry, he seems pretty well sold on the stock).

If the stock goes down as expected, you can buy shares at the market price and then sell them at the higher price you negotiated in the contract. If Acme takes off and shoots up 500 percent, you just tear up the contract and you’re only out the price of that contract. It’s still a loss, but at least you’re not the poor trader scrambling to buy up shares in the midst of a short squeeze.

The option limits your potential losses. It limits your profits as well, but, in the end, most people would likely conclude that the typically marginal reduction in profits is more than made up for in the drastic reduction in risk.

Ultimately, there are plenty of people who have made a lot of money through short positions, whether it be early market skeptic Jesse Lauriston Livermore, who made millions shorting the market prior to crashes in 1907 and 1929, or modern-day bears like Jim Chanos, who helped cast light on Enron’s dubious accounting practices.

And it’s important to remember that shorts play an important role in the markets. Without bears looking to identify and exploit weak companies, speculative binges and bubbles could be even worse. Short-sellers ultimately help balance financial markets, provide a necessary and valuable voice of dissent to the bulls, and help uncover fraud. After all, a market made up of nothing but the Larry’s of the world is most-likely not going to be a stable one.

However, pure short positions are difficult to profit from, which is why they’re so rare and employed successfully only by some of the market’s sharpest actors.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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