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May 20, 2008

The Ill-Logic of Shorting

The reason I don't short stocks is because I don't like the risk/reward ratio.

When you buy a stock -- go long -- the most you can lose is what you paid for the stock if the stock goes to zero as in bankruptcy. There is no cap on what you can gain, in Peter Lynch parlance, it could be a ten bagger. When you sell a stock you don't own -- go short -- the logic and the risk/reward ratio are reversed: the most you can make is what you were paid for the stock if the stock goes to zero as in bankruptcy. But your loses have no cap whatsoever, if the stock were to become a ten bagger you would lose ten times the money you were paid for the stock (unless you close your position in time).

This very clear logic cannot escape the smart money crowd so there must be something else in play. I'll get to that in a minute but first, let's review the mechanics of shorting.

By law you cannot sell something that you do not have and this applies to stock short positions as well. Since the short has to deliver the stock to the buyer, the short has to borrow the stock from someone. Typically his stock broker will lend the stock which is available to the broker from the margin accounts he carries. A margin account with a broker includes a clause whereby the margin account holder allows the broker to lend out the margined shares. Since the broker is now on the hook for the short shares, he wants collateral for this position. When you short a stock you have to leave the money you get with the broker. Should the stock rise, the collateral becomes insufficient and the short gets a margin call to put up more collateral. With a rising stock this situation can soon become a financial disaster.

But smart money is not so dumb and they find other ways to create the requisite collateral. Very often a short position is part of a more complex operation involving options. For example, if at the time you short a stock you also buy call options which give you the right to buy the shares at a certain price, these call options can serve as collateral for your short position. This is called a hedge because it puts a limit on your losses (and also on your gains).

An interesting byproduct of this hedge are the so called naked shorts, when more shares are sold short than exist in the market and the short seller is not able to deliver the shares to the buyer. The extra short position is not backed by shares but by options to buy these shares! But it could well be that the calls themselves are naked calls...

Plain shorting for an individual investor is a dangerous game to play. He is swimming is a sea full of smart money sharks. Shorts typically don't short a stock that is going up but, since "the trend is your friend," they short stocks that are going down and, as mentioned above, more than likely they hedge their short position with some sort of option play.

Happy investing!

Denny Schlesinger

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