Sell High-Buy Low
by Richard P. Halverson
Investors have spent much of the last 15 months in a bear market – particularly if you are invested anywhere near Silicon Valley. Some people have made and lost fortunes in less time than it takes to fill a mission. Are there any ways to make money in a gruesome stock market like this? Sure, go short.
It is simple. Sell a stock you don’t own. Watch the stock drop. Buy back the stock you didn’t own. Pocket a fat profit. It’s possible. It’s legal. The Church will even accept tithing on the profits. One little thing to watch out for – if the favorite stock you hate goes up, instead of down, you could lose money, perhaps lots of money, perhaps more money than you invested to begin with.
Hard Lesson
If the past year or so has taught a lot of investors anything it may be that the stock market doesn’t always go up. At least not in the time frame you want. A subsidiary point is that individual stocks don’t always go up. Sometimes not even in the long run. Some stocks actually go down and disappear.
Before going further I should make clear that it is true stocks generally do rise – over time. And the majority of individual stocks do rise – over time. But there are plenty of down times in the markets and plenty of stocks that may never fully get back to where they once were.
Bottom and Top
I am an optimist. Just because I am writing about shorting stocks after fourteen difficult months in the markets, I don’t want people to think that I believe shorting is the only way to invest. In fact, I was asked about my view of the market the other day. (Truth is I get asked about my view of the market every day.) This time I responded by saying, “I am sure the NASDAQ is closer to the bottom than the top!” My friend wanted to know how I could be so confident. I pointed out the NASDAQ has fallen more than 3000 points from its high of 5048. “It won’t go below zero.” I said. “So it can’t fall more than 2000 more points. Hence, it has got to be closer to the bottom than the top.” “Thanks for that helpful insight.” Was the derogatory response I received.
If we are closer to the bottom than the top why bring up shorting now? Well, you might be surprised how uninterested people are in learning about shorting when the NASDAQ is soaring through 5000. And even at this level shorting is a useful technique to know about. There are always stocks going down. The possibility of making money by shorting always exists. Be forewarned, however, it takes a much better investor to be good at selling stocks short than at buying stocks long.
Here is what you do. Find a stock you think will go down. Call your broker and sell it, even though you don’t own it. This is called selling short. Your broker will sell the stock and deposit the proceeds in your brokerage account. Normally, you cannot withdraw the proceeds from your account right away, a point I will explain later. If the stock goes down in price call your broker and buy the stock. This is called covering the short. If you buy at a price lower than the price you sold for you make a profit. An upside down view of the old idea of “buy low, sell high” i.e. “sell high, buy low”.
An Example
For example, suppose you had been smart enough to sell 1000 shares of Amazon.com short at $89 a share in January 2000. You would have received $89,000. Then suppose you had been just as smart to buy it back a few weeks ago at $9. The purchase would have cost you $9,000. You would have made $80,000. Or suppose you had shorted 1000 shares of CISCO Systems in March 2000 at $80 a share. At the time CISCO was the world’s largest company measured by market value. Then, suppose you covered it in May 2001 at $20. You would have made $60,000. (1000 X $80 = $80,000 less 1000 shares X $20 = $20,000 a profit of $60,000) By the way CISCO is now only the world’s 17th largest company. I’m sure people shorting helped drive it to down that embarrassingly low level. Or, as long as we are dreaming, how about Quokka Sports? You could have sold it short at more than $800, adjusted for reverse splits. Unfortunately, for the shareholders and employees of Quokka Sports it is now worth $0. Oh how great hindsight is? There were a lot more investors buying these stocks at the top than selling them short.
Before you reach for your Internet connected Palm Pilot m505 on the OS platform (Palm Inc has dropped from $95 to $8) to place short orders there are a few more things you should know. First, stocks don’t always go down. If the stock rises and you wind up covering at a higher price you will lose money — possibly lots of money. With a short the loss is potentially cataclysmic. Here’s why. When you buy a stock you can’t lose more than what you have invested. Remember my little quip a few paragraphs ago about the NASDAQ not going below zero? It is true. A loss of 2000 or so points is all you can possibly suffer in the NASDAQ. Same with Amazon.com. If you bought 1000 shares at $89, which many people did, the most you could lose was $89,000. I know that sounds terrible. But imagine shorting Amazon at $89 and then watching it double to $178. That is a loss of $89,000 and you are still exposed. Then imagine watching it double again to $356. The loss is now $267,000 and still rising. (1000 X $89= $89,000 received less 1000 shares X $356 = $356,000 when covered = a loss of $267,000) You get the picture. This is in fact what was happening to investors who thought some technology stocks were way over priced in 1999 and started shorting them too early. The stocks went way up before they started back down. Your losses when shorting can be almost infinite.
Next Thing to Know
This leads to the second thing you should know. In order to short stocks you will need to open a margin account with the broker. Opening a margin account is not a big deal. A margin account allows you to have both assets and liabilities or loans in the same account. Your assets are collateral for your liabilities. If your liabilities or losses in the account exceed a certain percent of the assets in the account you will get a call from the broker to deposit more collateral. If you can’t deposit more collateral the firm has the legal authority to sell your assets. And they will do it. This is true even if they haven’t been able to reach you. Your personal broker does not make the decision. In fact, many of the limits are controlled by federal regulation. The timing of a margin call or asset liquidation can be very bad. The financial institution cannot risk letting the loss in your account grow if you do not have the assets to cover the it.
When you put in an order to short stock you may not get the price you expect. Regulations require that a short sale can only be done on an up-tick in price. So, you might put in the order to short only to have the stock trade straight down. This mean you never were allowed to sell. This rule exists to help provide orderly markets and prevent short raids on stocks. There are no special rules surrounding your purchase when you are covering the stock.
You should understand that when you sell a stock you do not own. your broker needs to borrow the stock so that it can be delivered to the buyer on the other side. Borrowing stock is a whole new subject that we won’t tackle here. In most cases the borrowing will be completely invisible to you. However, there are a few things you must be aware of. On rare occasions the broker may not be able to borrow the stock for you. This means you will not be able to complete your short sale. On even rarer occasions you may be short a stock when a sudden demand for it arises. The broker is forced to return the borrowed stock but is unable to find a new source to borrow. Your only alternative is to go into the market and buy the stock to replace the borrowed security. This will nearly always occur at a very bad time, probably cost you a bundle and it is completely outside your control.
Further, there will be charges for borrowing the stock. And if you short the stock of a company that pays a dividend you will be required to make that dividend payment to the lender of the stock. These charges will be automatically deducted from your margin account. You may also earn some money. When you short or sell the stock your account receives cash. Your broker holds on to the cash as collateral against the obligation to cover the stock at some point. In the mean time the broker invests that cash somewhere just like a bank. You are entitled to at least a portion of the earnings on the invested cash. This is called a rebate. My experience is that the broker will not credit your account with a rebate automatically, you need to ask for it. My experience also is that small investors with limited negotiating power often cannot get it. But you should try.
Not for Casual Investors
By now it should be clear that shorting is not for casual investors. Lots of people like to be able to invest in stocks then leave them on autopilot. Just checking in occasionally to see how much they have made. You should never do that with when you are shorting. First of all stocks really do tend to go up over time. Consequently, if you choose to short you are swimming against the long term current. Second, sharp rises in stocks can occur without warning. It is no fun to be short some suffering company only to read that Giganticus Inc. and Humongous Ltd. have just launched a bidding war for the right to devour the dog. The stock is up a 100% and rising fast. And. of course, there are all the things that can occur in your margin account without additional authorization from you.
Be happy, there really are ways to enjoy bear markets and get rich while everyone else around you is losing their retirement. And don’t worry, it is all at an arm’s length transaction. You will never meet the person who lost all that money you made. Short stocks you don’t own and coin that new phrase you’ve just learned – “Sell High and Buy Low.”
2001 Meridian Magazine. All Rights Reserved.
