Short Selling is Fraught with Risk: The Mechanics

By: Dr Norman D - September 01, 2020 02:31pm EST
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Short selling can be extremely profitable but it is fraught with risk
Short selling can be extremely profitable but it is fraught with risk

He of the Black Heart:

No-one and nothing is as poorly understood as the short seller. The short seller is the ultimate individualist. Bulls are creatures which move in herds while bears and especially the great grizzlies are loners, and real alphas. The great stock-market short sellers are the greatest of bears and like these animals they hunt alone. They are generally hated as they make fortunes when everyone else is losing their shirts. During the 1920’s the greatest of all bears, Jesse Livermore and Joseph Kennedy (the father of JFK) were accused of ‘un-American activities’. This is ridiculous as short selling is both legal and provides important liquidity when stocks are plunging.

Short-selling is not what it used to be as there are now many ETF’s which enable one to short stock indices. There are also put options which enable one to take advantage of declining share prices but we will discuss options another time.

Short selling can be extremely profitable but it is fraught with risk and has become a professional activity but it needn’t be. To be a short seller, besides nerves of steel, you need some administrative requirements. You need a margin account with your broker, which most traders will have. When you sell short, your brokerage firm lends you securities which other investors have bought on margin or borrowed against their stock position for any reason.

(If you have a margin account you will have signed a form whereby you have given your broker permission to loan out your securities until you are debt free). It’s a scary document in which they tell you what they are going to do to you if you can’t meet your margin calls if any.

You then sell the securities you have been loaned, hoping to buy them back when they fall in price, and you then pocket the difference. (Remember that the ‘owner’ of these securities thinks that they own them on margin so you will have to pay any dividends which fall due). You will have to pay broker loan charges too. The house always wins as you know.

Can you short sell any stock you don’t like?  in theory yes, but in practice that’s a bad idea. If you sell a stock short and it starts going up, you are going to panic. If the stock you sold short is illiquid, your panic is justified, as you may not be able to easily buy that stock to cover it.

So here are some rules for short selling:

  1. Only consider short-selling large well capitalized and liquid stocks.

  2. Check the ‘float’ to make sure there are plenty of stocks available.

  3. Check the ‘short-interest’. This will tell you how many stocks are in ‘short position’. You don’t want to be joining a few big hedge fund managers who are all shorting the same stock as it could move violently against you.

  4. A stock can only be sold short if the previous trade was a ‘buy’. This is called the ‘uptick’ rule. An attempt to make it even harder for short-sellers.

After making a profit you will need to buy the stock which is know as ‘covering your short’. Now you know why the market often goes up sharply after falling for a few days. This is covering by short sellers. Sometimes they may be the only ones inclined to buy which is why banning short-selling would be counter- productive, as short sellers provide liquidity to the market.

In the recent past, the London based American trader Robert Beckman sold stocks on the London stock exchange in 1974, when the market tumbled 90%. In particular, he sold Rolls-Royce short before it went bankrupt. Selling a stock short which goes bankrupt is the 'perfect short’ because it is not necessary to cover the short sale and the entire amount is profit.

There are now many ETFs (Exchange traded funds) which move inversely to stock indices and so go up when the indices go down. It is also possible to buy put options which give the investor the right (but not the obligation), to sell a stock at a specific price. This a much safer way to short stocks but it is way less efficient and is also not for novice investors.

Short sellers tend to be larger than life alphas with preceeding reputations. Jesse Livermore for example was known for his philandering. When he was selling short, he would remain in a closed room which only had the ticker-tape and no other distractions. He would leave for his dalliances, but in the midst of amourous situations, he would suddenly flee back to his ticker-tape. He made over $100 million from short sales, the equivalent of billions today. He became depressed and blew his brains out in a toilet.

Joseph Kennedy, also known for his philandering, started selling short when his shoeshiners started tipping stocks. These were the equivalent of today’s Robinhood traders.

Robert Beckman flashed his wealth about ostentatiously. He had a dog with its own portfolio (which was legal in the UK at the time). The dog’s portfolio showed better performance than most of his clients. When he was asked why, he replied; ”My dog does not stick his nose into things he does not understand”. He was also a philanderer.

Do you have the alpha to be a short-seller? We at macrotomi have the moxy for this. Subscribe and we will keep you posted.

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