Frank looked up from his newspaper and sighed. It had not been a good week in the markets, and the short-term forecasts from the analysts were not very optimistic. Of course, if he wanted to profit from a market downturn, he could always buy put options on one of the market indexes, but he felt that option trading was not the answer. I sure wish that I had stock to sell right now, he thought. Then I could buy it back at a big discount in a month or so.

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Of course, Frank can do exactly that by placing a short sale. Read on to learn more about short sales and how they can help you through market downturns.

What is a short sale?

By definition, a short sale is a transaction in which the seller does not actually own the stock that is being sold, but borrows it from the broker-dealer through which he or she is placing the sell order. The seller, of course, then has the obligation to buy back the stock at some point in the future. Short sales are margin transactions, and their equity reserve requirements are more stringent than for purchases.

Short sales are executed by investors who think the price of the stock being sold will decrease, usually in the short term (such as a few months). It is important to understand that short sales are considered risky because if the stock price rises instead of declines, then there is theoretically no limit on the investor’s possible loss. As a result, most experienced short sellers will put a stop-loss buyback price on their orders, so that if the stock price begins to rise, the short sale will be automatically covered with only a small loss.

Advantages of the Short Sale

The main advantage of a short sale is that it allows investors to profit from a drop in the price. If a stock is selling for $70 a share and then a major company scandal is exposed, it is seemingly impossible to make money by purchasing shares at this point. The only sensible course of action is to borrow shares of the stock and sell them, while the price is high, and then buy them later after the price has dropped. Short sales therefore allow investors to buy low and sell high, albeit in reverse order. Furthermore, short sales allow for leveraged profits because these trades are always placed on margin, which means that the full amount of the trade does not have to be paid for. Therefore, the entire gain realized from a short sale can be much larger than the available equity in an investor’s account would otherwise permit.

Disadvantages of the Short Sale

As stated earlier, one of the main drawbacks to short sales is the inherent risk involved. A short seller that has not covered his or her position with a stop-loss buyback order can suffer tremendous losses if the stock price does not decline.

For example, consider a company that becomes embroiled in scandal when its stock is trading at $70 per share. An investor sees an opportunity to make a quick profit and sells the stock short at $65. But then the company is able to quickly exonerate itself from the accusations by coming up with tangible proof to the contrary. The stock price quickly rises to $80 a share, leaving the investor with a loss of $15 per share for the moment. The price may recede to where it was before, but it’s not likely the investor will see a profit in this scenario. And, of course, if an investor sees a disappointing earnings report on the horizon and shorts the company’s stock beforehand and then the company unveils some new miracle product that sends the stock price heavenward, the investor had better have a stop-loss buyback order on the books, or he or she will have to eat the entire rise in the price of the stock.

There is another major obstacle that short sellers must also overcome. The markets have historically moved in an upward trend over time, which works against profiting from broad market declines in any long-term sense. Furthermore, the overall efficiency of the markets often (but not always) builds the effect of any kind of bad news about a company into its current price. If a company is going to have a bad earnings report, in most cases the price will have already dropped by the time the report actually comes to press. Therefore, in order to make a profit, most short sellers must be able to anticipate a drop in stock price before the market has had a chance to factor whatever is causing the decline into the price.

Many successful short-sellers profit by finding companies that are fundamentally misunderstood by the market (i.e. Enron and Worldcom). For example, a company that is not disclosing its current financial condition can be an ideal target for a short seller.

Conclusion

While short sales can be profitable under the right circumstances, they should be approached carefully by experienced investors who have done their homework on the company they are shorting. Both fundamental and technical analysis can be useful tools in determining when it is appropriate to sell short.

by Mark P. Cussen, CFP®, CMFC

Mark P. Cussen has over 13 years of experience in the financial industry, which includes working with investments, insurance, mortgages, taxes and financial planning. He has two years of experience in writing and editing insurance and securities test training manuals, as well as other financial topics. He has also worked in in retail, discount and bank brokerage systems and been involved in a venture capital enterprise in the oil and gas sector. Mark has a Bachelor of Science in English from the University of Kansas and earned his CFP®; designation from the Bloch School of Business at the University of Missouri-Kansas City in August of 2001.