[This just teaches a bit about how to short the market. Hope its useful to some of you with money in stocks - John]

BOOKS & TRADES #14

(We will gladly add or delete names and addresses on request)

Friday, May 28, 1999

A periodic bulletin from Dr Alexander Elder Director, Financial Trading Inc.

Dear Friend,

Have you heard the latest news  that stocks occasionally go down!?!?! And when they do, they fall faster than they rise. People who fall off mountains fly down faster than they climbed up. Canny traders profit from stock declines faster than from most rallies.

Many beginning traders tell me they do not understand how selling short works in practice. So, here it goes.

You know how to make money when stocks rise. Suppose you look at a stock selling for $50 and your analysis indicates it is headed for $100. You buy it at $50 and sell after it reaches $100, pocketing the $50 profit, minus the commissions.

Now visualize another situation. You see a $100 stock that is weak and your analysis indicates it is likely to decline to $50. Selling short will allow you to profit from that decline. Call your broker and say to him, Sell short a share of such and such stock. The broker will go into his back room where he keeps his clients stock certificates. Hell find the stock you want to sell short in some other clients folder. Hell borrow that share certificate from the other clients folder and leave an IOU in your name (a note that says you have borrowed that clients certificate and will return it on demand). Furthermore, the broker will take $100 out of your account and put it away as a security deposit, to make sure you have enough money to deliver the stock back. Hell then turn around and sell the borrowed share in the market, realizing $100 that hell put away in his safe for safekeeping.

Suppose the stock goes down, as you expected. When it reaches $50, you call your broker and say, Cover short. Hell reach into his safe where hes keeping the proceeds from the sale of that stock, take out $50 (because thats how much the stock cost today) and buy the stock. Hell put the certificate back into the folder from which an identical certificate had been borrowed and tear up your IOU. Hell return to you the $100 he had kept as a security as well as the $50 profit (remember, you had realized $100 from selling that stock to begin with, but it took only $50 to buy it back).

Selling short is accomplished by selling borrowed stock and returning it later, after buying it back at a lower price. Of course, today no one physically goes into the back room to look through folders and find a share certificate to borrow  the whole process is done by computers. The bigger your brokerage firm, the more clients it has, the better your chances of being able to borrow any stock you want to sell short. With less popular stocks and with smaller brokers you may hear Not available when you order to sell short.

Why would anyone lend his or her stock to someone else? Because nobody asks for their permission! A person who opens a margin account automatically gives his broker permission to borrow his shares  it is an old rule of >brokerage industry.

Are there any problems with selling short? First of all, it pays to have an account with a large broker who has a wide selection of stocks available for shorting because his other clients actually own this stock. Next, the stocks you sell short should be liquid. Not only are illiquid stocks harder to borrow  they are subject to more violent swings, sending short-sellers scrambling for cover.

Many investors are afraid of shorting because theyve heard it involves unlimited risk. If you buy a stock at $50, then the most you can lose is $50, since a stock cannot decline below zero. But if you sell short a $100 stock and it rises to $200, $500 or even $1,000, you still have to buy it back in order to return it, making you responsible for the entire rise. To which I say: USE STOPS! If you sell short at $100, then put a stop at $105 or $110 or $120  whatever your system dictates. If the stock you expected to fall starts to rise, you will be stopped out. Any fool trading without stops who watches a stock go against him by a $100 per share and does nothing, deserves his catastrophic loss!

Another argument against shorting is that historically the stock market has risen about 3% above the rate of inflation. Short-sellers swim against a slow historical tide. That historical rise is real, but violent declines that last weeks, months, or even years are just as real.

A serious trader must learn to sell short. You already know that stocks go down  thats how you lost money on some of your purchases. Start looking at the markets with both eyes  scan it for good stocks to buy while also looking for overvalued and declining stocks to sell short. Run your trading account like a small hedge fund  have some long and some short positions.

One of the themes I have been hammering on in several recent Traders Camps is how to sell short and run a portfolio like a small hedge fund. I give homework to campers: find a stock you hate and short 100 shares of that dog within 30 days of leaving the Camp. Even if you havent been to our Traders Camp, try it  youll like it!

-- John Ainsworth (ainsje@cstone.net), July 08, 1999

Answers

John,

Thank you for your clear and simplified instruction for the novice. I appreciate your time and effort. I do hope you continue to post things like this. I'll keep my eye out for your postings in the future.

Regards.

-- Leslie (***@***.net), July 08, 1999.

Thanks so much for these insights. I have heard just enough about this subject to really wonder how it worked. I have a much better idea now.

-- VeryWary (MakesSense2Me@logical.com), July 08, 1999.

I believe that if you short a stock and it rises but has not reached your stop, the broker may require additional money from your account to cover the difference. Also, if it does reach the stop and gets covered, you need to come up with the difference between, in the given example, the $100 and the actual cover price.

Shorting stocks in a rising market includes timing problems. If your stop is too tight, you may stop out prematurely. But a looser stop could require more cash to cover the, presumably temporary, rise in the price of the stock.

Jerry

-- Jerry B (skeptic76@erols.com), July 08, 1999.

Put options are much safer and less risky. A small move in a stock means a large move in an option. In other words, options can make you much more money!

If the market goes against you, you can only lose the money you put up for buying the put option. Going short on a stock, could bankrupt you! DON'T DO IT!!!!

-- freddie (freddie@thefreeloader.com), July 09, 1999.