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TRADER'S NOTEBOOK


To Short Or Not To Short?

08/06/02 01:56:15 PM PST
by Neil O'Hara

That is the question. Here's a detailed discussion of short selling.

Most investors are familiar with long stock portfolios. In long stock portfolios, you buy shares that you expect to increase in price over time as the companies prosper. Sometimes you're right, sometimes you're not. Eventually, you sell the shares, because either the price has risen to realize the bright prospects you foresaw or those prospects have changed for the worse. When you do sell, you simply place the order, receive the proceeds a few days later, and move on to your next investment.

Suppose when you were deciding which stocks to buy you came across other stocks that seemed overvalued at the current market price. They might include companies with bright prospects that trade at a premium to your preferred picks, or companies with poor market position, lower margins, or slower growth prospects that you believe are not reflected in the current price.

You might feel the case for a particular stock price to fall is so compelling you would like to take advantage of the anticipated drop. You can do this by selling short.

HOW IT WORKS

Short sellers sell shares in the expectation of buying them later at a lower price. They are referred to as "short" sellers because they do not own the shares they have sold.

Trades cannot settle until the seller delivers the shares to the buyer, so a short seller must borrow the shares. The broker handling the transaction will arrange this through its stock loan department. Trading rules require short sellers to "locate" shares before the order is placed, and the trading desk will not execute an order without the prior approval of the stock loan department.

There is a special rule governing the execution of short sales, called the "uptick" rule. Each trade reported on the tape has a tick associated with it, indicating the direction of the last change in price of that stock. A trade at a higher price than the last sale is a plus tick, while a price below the last sale is a minus tick. A trade executed at the last sale is considered a zero-plus or zero-minus tick, according to the direction of the last move in the price. Short sales are only permitted on a plus or zero-plus tick. (On the Nasdaq, a short sale may also be executed on a plus-tick bid, meaning that the last change in the best bid by a market maker was an increase in the bid price — even if this is lower than the last sale price.)

The proceeds of a short sale are retained by the broker as collateral for the loan of the shares, and that collateral is periodically adjusted to reflect subsequent changes in the share price. The cash earns interest, but a retail investor typically does not receive any (it is retained by the broker). Institutions receive a "stock loan rebate" of some of the interest, typically 70-80%, but subject to negotiation with the broker. The broker keeps the rest of the interest as a fee for arranging the stock loan.

Federal Reserve Board rules require short sellers to put up an initial margin against a short sale. Similar to a purchase on margin, the amount required is either cash equal to 50% or securities with a value equal to 100% of the proceeds of the short sale. The return on the cash or securities is credited to the account of the short seller.

Once the short sale has been executed, there are two investors who think they are long the stock — the buyer of the shares sold short, and the owner of the shares lent. The total number of shares outstanding has not changed, so only one can receive dividends or other distributions directly from the company. The short seller is therefore liable for any distributions payable, and the stock lender will receive money from the short seller rather than the company. The stock lender also surrenders the other rights of a shareholder, such as voting rights.

Buying shares in the market, a process known as "covering" the short, normally closes out a short position. If the share price has declined, the cost of covering the short is less than the amount received from the short sale, and the short seller has a gain equal to the difference, less the costs of trading. If the price rises, the short seller will incur a loss.

THE RISKS OF SELLING SHORT

Selling short is riskier than buying stocks. From the broadest perspective, if the economy is growing, the efficient market theory suggests that the equity market will be an upward-biased random walk. In the aggregate, short selling is therefore at a disadvantage because of this upward bias. There are periods like the last two and a half years that show a downward bias favoring shorts, but ultimately there is more risk being short than long.

A long position is a positively skewed risk because the maximum loss is limited to the cost of the stock, while the potential gain is unlimited. A short position is the reverse, so the risk is negatively skewed; the maximum profit from a short position is limited by the sale price, while the potential loss is unlimited. In reality, stock prices do not surge indefinitely, although they do occasionally double or triple in price (or increase by even larger factors) in a very short time. Stocks also do not plunge to zero instantly, although drops of 50% or more do occur.

The credit policies of brokers introduce an additional risk for short sellers. Minimum equity is usually set at 30% for long positions and 35% for shorts, so there is a smaller margin of safety for a short seller. Brokers also have the discretion to alter their credit policies at any time without notice and sometimes raise maintenance margin requirements on a particular stock just when it becomes difficult to borrow the shares.

The lopsided risk against short sellers is real enough, but it might not matter so much if short sellers did not have to borrow shares. This is the critical difference between trading long or short. Long holders are in complete control, free to sell as they please but never forced to do so (unless they buy on margin and suffer a margin call). Short sellers are also free to trade, but they can maintain their position only so long as they can borrow the shares they have sold. Long holders, whose economic interest is the exact opposite of the short sellers who borrow, indirectly control the supply of shares available for loan.

Shares lent to short sellers are subject to recall at any time. If the stock lender sells out of the stock, the shares must be recalled to settle that trade. Unless the buyers are willing to lend their stock, the number of shares available to short sellers will be reduced. If the lender wishes to exercise voting rights, he or she must call back the shares first. If the lender transfers shares from a margin account to a cash account, the shares must be recalled because stock lending is not permitted in a cash account. Some corporate actions (such as tender offers) require delivery of the stock, so most shares will be recalled before the action becomes effective.

Sometimes the appetite of short sellers exhausts the supply of shares, and the shares become difficult to borrow. Stock lenders and stock loan departments of the brokers take advantage of hard-to-borrow items by charging more. At first, the amount of the stock loan rebate paid to institutions will be reduced or eliminated, but if the supply becomes very tight the lenders may demand an additional fee for the use of their stock. Eventually, it may become impossible to borrow stock at any price, at which point the stock loan departments must issue recall notices.

Short sellers who receive recall notices must return the shares, forcing them to buy shares in the market. This is called a "short squeeze." Ignoring the notice is not an option, because the broker has the right to "buy in" the short position at the expense of the seller. A buy-in on behalf of a recalcitrant customer will be executed as a market order, which may prove to be expensive in the middle of a short squeeze.

Once a short squeeze begins, it can easily develop its own self-sustaining momentum. Buying pressure from shorts seeking to cover will drive up the price, reducing the gains (or increasing the losses) of other shorts who may in turn start to cover. In extreme cases, short sellers may be subject to margin calls. As the price rises, long holders will start selling, but if their stock has been lent out, this does not alleviate the supply shortage for the remaining short sellers. Relief comes in the form of selling by holders who were not stock lenders to those who are, or when the short interest has been eliminated.

Opportunistic traders may take advantage of the price spike caused by a short squeeze. Some simply buy to push the price up in an effort to stampede the shorts to cover. For best effect, they buy in a cash account so their stock is not available to the short sellers. Others who hold shares in a margin account may transfer them to a cash account, forcing a recall in an already tight market and then selling into the buying frenzy that follows.

MONITORING SHORT INTEREST

Information on short interest for US equities is available once a month and is published in The Wall Street Journal. One key indicator is the "short interest ratio," defined as short interest divided by average daily volume. This indicates how many days of normal trading would be required to eliminate short interest, and is a measure of the potential for a short squeeze. Another good statistic is short interest as a percentage of the number of shares outstanding (or better still, percentage of the free float). If new shares are being issued either in a secondary offering or through a merger, the number of new shares to be issued as a percentage of the existing float is important. In each case, a high ratio or percentage indicates a greater risk of a short squeeze.

Large amounts of short selling today relate to hedging activities, including arbitrage, options, and other derivative instruments. This type of short selling does not imply a negative view of the stock, just that the seller is managing its risk and exposure. It still increases the risk for other short sellers because it absorbs some of the supply of shares available for loan.

Avoiding the painful consequences of a short squeeze is one of the keys to successful short selling. You must study the indicators of short interest before selling short and monitor them carefully while maintaining a short position.

DO-IT-YOURSELF HEDGE FUND

Short selling can be an effective way to leverage the research you do on your stock portfolio, and it reduces your exposure to general movements in the market. If your stock picks are perfect, you make money both on the long positions as they go up and on the short positions as they go down. You end up making a higher return with less market risk than you would have on a simple long portfolio.

Professional investors agree that seems like an attractive proposition. It is the fundamental concept behind many hedge funds, which are the fastest-growing area of the money management industry. Including short selling in your investment strategy lets you create your own hedged portfolio without paying the management fees of a hedge fund.

Many hedge funds take this one step further by using leverage. If short positions cut the risk of a portfolio, the increased risk of leverage is made more tolerable, and the opportunity for higher returns is created. As long as the return on the incremental investments exceeds the cost of borrowing, the return to investors will be enhanced.

Most investors consider only long investments, and that may be appropriate for many. Short selling can leverage your research, but there are incremental risks as well as potential benefits. You should understand the risks before you start selling short, especially the risk of a short squeeze and how to avoid getting caught. Provided you are willing to do the additional monitoring needed, selling short can be a profitable investment strategy that improves your returns and reduces the risk of your portfolio.

Neil A. O'Hara has worked in the financial services industry for almost 30 years. He was a hedge fund manager and portfolio manager for various funds and has focused on foreign merger arbitrage.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Neil O'Hara




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