jaudio shorts

The Long and Short of Shorting

Rating: 2.25 not yet rated(8 votes)    Vote:

You are logged in as | Logout

In a recent blog entry, Keith Barton asked to see an article regarding how to short. His recent blog, "Double? Ultra? That means the brick wall is twice as hard", explains his recent dealings with short ETFs. Though I am far from an expert, I will give the down and dirty of shorting and several reasons you should do it. I will begin by discussing the mechanics of shorting, then discuss how it pertains to the SLO, and wrap it up by discussing the pros and cons of shorting. As many of you know, my portfolio is made up entirely of ultra short ETFs.

First of all, we have to know what shorting really is. Shorting is when a stock trader "borrows" a brokers stock for a particular company and sells it on the open market. After a period of time, the trader returns the borrowed stock back to the broker by buying it back on the open market. If the stock has fallen in price, the trader returns the stock to the broker and pockets the change. The buying back of a shorted stock is called "covering". If the stock has risen in price when the trader covers, then the trader pays the difference and loses money. The goal for "short sellers" is to see the stock fall in price as much as possible before buying it back to returning the shares to the broker. The bigger the fall in stock price, the bigger the payday for the short seller.

In the SLO, you cannot short an individual stock. It took me a while to figure this out. When the game started, I was extremely busy and I didn't have a lot of time to learn the Marketocracy site as it pertained to the SLO. I wanted to short individual stocks, and since I couldn't, I decided to short the market by buying long stakes in Exchange Traded Funds that specialized in shorting. This has actually been better for me since it gave instant diversity and allowed me to do what I wanted in the first place--short the market. I am not aware of the many choices of short ETFs that exist and are able to be traded on Marketocracy, but I am very familiar with Pro Shares short and ultra short ETFs, and my portfolio is stacked with them. To get a full listing of the Pro Shares ETF offerings, go to proshares.com and click on the "short and ultra short" icon, as our SLO brother Keith Barton did. I have been told about other companies offering short ETFs for the Chinese markets, but I have done no research on them at this point in time. My suggestion would be to spend 20 minutes of efficient research to see what is out there and then see if it can be traded on Marketocracy or your personal portfolio. With Proshares, you can also get lower risk short ETFs if the Ultra Shorts are a little too wild for your taste. Instead of getting DXD, which seeks to inversely double the Dow, you can get DOG, which seeks to be a perfect inverse match to the Dow.

Now for the Pros and Cons of shorting. The biggest Pro that I see with shorting is that few people do it. To defeat the competition, you must have an edge. Shorting can be the edge because few do it. Shorting is also much easier than it used to be due to the abolishment of the "uptick rule", a subject I covered in an earlier blog entry. Everyone knows how to buy long because that is what we have been taught since the beginning. Shorting has existed for many decades now, but has never been that popular. Some believe that it is ethically wrong to bet (and hope) that a company will go down and suffer. If you want to beat the other guy, you must do what the other guy is not doing, and shorting falls in that category. Look back at the history of any stock or index . . . there are periods of high times and periods of low times. No one is immune to the cycles, even the great Warren Buffett. Don't believe me? Check out what happened to Berkshire Hathaway. Those investors that bought BRKA at $78,000 at the beginning of 1999 probably cursed the genius less than a year later when it was sitting a little above $42,000. Most people believe that when the times get tough, you just need to buckle down your research tools and find that one gem that will rise as the markets fall. Hogwash. Sell the market or stock short and profit as it goes down. If you buy long, you beat the market when you lose 15% on an investment while the S&P is losing 20% during the same time period, but who wants to lose money? I'd rather stuff my money in a bank and let inflation take its toll than to have large percentages blown away in a bear market. By shorting the market, especially in a bear market, you can eek out gains while everyone else is losing. However, even if you don't eek out gains, the shorts can provide a hedge that will reduce the damage to your portfolio while you wait for the market to turn the corner. Want to know another great thing about the short ETFs? They pay dividends, too!

Another pro with shorting is that you can use the same research in shorting a stock as you do in buying a stock long. What parameters do you use to determine whether or not to buy a stock long? P/E? Technical analysis? Historical cycles? Lunar Cycles? You use research to determine what makes a stock an attractive buy, and you can use the same research to determine what makes a stock an attractive short sell. What makes a company a bad buy? What makes a company's stock take a significant dive over a 6-12 month period? Figure it out, and you can be successful at selling the stock short. I have never understood traders who can put time and research into picking successful long buys while saying at the same time shorting is "too risky". Everyone has been trash talking Fannie Mae recently, and if you believe what you are saying, put your money where your mouth is. Would you short Fannie Mae in your real life portfolio? How far will Fannie Fall? At the end of September, I dumped on the big banks in my blog "An October Reckoning", and since then Citi has went from $48 per share to about $32 per share. Go compute that percentage. You can stack the odds in your favor by shorting in a bear market. China may be in bubble territory right now, so if you could short the China market and the bubble bursts, you celebrate while others cry. It is the ultimate contrarian play. . . sell the bubble market short when everyone is buying. It's dangerous ground in the bubble, but the payoff can be big if you can tolerate the risk. If you can figure out how to spot a company that is going to run itself into the ground, then you will be an incredibly successful short seller.

Now for some of the cons.

Let's use Apple stock as an example of how shorting can't pan out as well as longing a stock. In mid 2006, AAPL was at $50 per share. Now it is over $160, a three-fold gain. If you short a stock at $50 per share and it drops to zero, you make $50, or 100%. If it goes to $160, you have lost over 300%. There is no profit ceiling when you buy long, but there is a profit ceiling with shorts. At the same time, there is a bottom when it comes to losses when you buy long. When you sell short, there is no bottom and the possibility of unlimited losses exists.

Another con is that the stock market, when taken in the long term, always tends to go up. According to the Leuthold Group, a Minneapolis money manager that researches market history, the market goes up 66% of the time and down 34% of the time. Take any twenty year period (as long as you aren't starting on October 29th, 1929) and you will have an overall gain. You will not make money shorting in the long term. Shorting is effective only when you hit it toward the beginning of the bear market or if you are talented enough to spot the bad stocks during a market bull. Berkshire Hathaway plummeted over 40% after 1999, but it turned upward and erased the losses in about 4 years. It is more about timing with shorts, and most people get the timing all wrong. With shorts, you must be a correct market timer two times, once when picking the time to short and another when to cover the short. Since the market is a going up 66% of the time, the odds are against you in hitting it close to perfect both times. When shorting a stock or an index, you must have a pre-determined exit point and stick to it.

There are dangers of losing big in short selling, and I recommend practicing with Marketocracy for a while before trying it in the real world. However, by careful research and practice along with some humility, shorts can be an addition to a portfolio that can pay off.

There are several terms associated with shorting that I will not talk about here, only because I can link you to people that can articulate it so much better. Below you will find two examples, one from Marketocracy and one from fool.com. Marketocracy explains the terminology, and the fool article has answers to frequently asked questions.

http://www.marketocracy.com/cgi-bin/WebObjects/Portfolio.woa/ps/ArticleViewPage/source=MdEcEdBlEbHgJmKiMaKiAbDm

http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

I tip my hat to the SLO leaders; I have watched you from the bottom for a long time now. It's coming down to the home stretch, now let's see if I can catch up.

--Jonathan