When and why to sell a stock short; rules and strategies (Pt 1)

Xray short sellling vision

Many investors have heard of the concept of short selling and perhaps many of those people are familiar with the rules of short selling and the strategies behind doing it.

It is intrinsically a very risky move as you are betting against the upward trend of the stock market in the hopes that a stock will go down in price but when used strategically with other long positions or on a case by case basis, it can be very profitable.

When I think of describing the concept of short selling, I almost think of it as the opposite of investing because you believe a company’s stock price will rise. That is, you believe the stock price of a company is overvalued and that it will drop when the market corrects.

Thus, the seller is selling high and then buying low. The profit will be the difference between the price you eventually buy the shares for and the (higher) price you sold them for (minus brokerage fees).

The problem however, is that when value investing in a stock, you can hold the stock forever waiting for it to increase and your losses are limited to the capital you contributed whilst when you are short selling, your losses are not limited and waiting longer time frames become very risky and costly.

Edit 22 September 08 – Short selling no longer possible on the ASX.

Short selling stock procedure

Short sales are orders to sell securities that the seller does not own. It order to do this, a seller must follow the short-sale procedure below:

  1. The seller must borrow the securities from a broker before their sale.
  2. The seller must inform their broker that the order is a short sale before the transaction is placed. The broker must also be a broker that engages in short sales of shares.
  3. The seller must return the securities at the request of the lender or when the short sale is closed out. The short seller does not get the proceeds of the short sale.

Rules of short selling
The following three rules apply to short selling:

  1. The uptick rule states stocks can only be shorted in an up market. Therefore, a short sale can only trade at a price higher than the previous trade. ‘Zero ticks’ occur where there is no price change and are defined as keeping the sign of the previous order. This rule is in effect to prevent traders known as “pool operators” from driving down a stock price through significant short selling, and then buying the shares for a large profit.
  2. The short seller of stock must pay all dividends due to the lender of the security. This is because you effectively have a negative number of the shares.
  3. The short seller of stock must also deposit margin money to guarantee the eventual repurchase of the security.

When to short sell stock

Having outlined the risks of short selling, the following types of companies were identified by Investor Guide as targets for the short sale of their stock:

  1. Small capitalisation companies that have been driven up by speculative investors, especially companies that are difficult to value or those with minimal revenue (see P/E below).
  2. Companies whose P/E ratios are much higher than can be justified by their growth rates.
  3. Companies with bad or useless products and services.
  4. Companies riding the latest trend that are unlikely to last.
  5. Companies that have new competition entering the market.
  6. Companies with weak or worsening financials (bad balance sheet, negative cash flows, etc.).

It is never a good idea to short a stock which is about to be taken over by another company as the offer may come at a significant premium and significantly increase the stock price; leaving you in an exposed position.

See part two for the short selling strategies that are typically employed by investors.

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