Short Selling Mechanics

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Short Selling Mechanics

Post  Max on Sun Nov 07, 2010 10:36 pm

Short selling involves borrowing stock from someone else to sell on the market and then buying it back later at a lower price after the price has fallen. The risks:

1. The price goes up. Obvious, but you have unlimited potential losses in this case, since a stock can rise indefinitely as opposed to going long (buying a stock), where your losses are limited to the amount invested.

2. You must pay interest to the person/firm you borrowed the stock from. Another interesting point is that in the case of blue chip stocks (large, well established, stable, generally dividend payers), since the person/firm you borrowed the stock from no longer owns the stock, and you have sold the stock to someone else, neither you nor the person/firm you borrowed from will receive the dividends. However, it is typically required that the short seller will cover any dividend payments while they have borrowed the stock. This could be considered an additional interest cost but is avoidable depending on timing, and creates an incentive for short sellers to cover (buy back in) before a dividend payment.

3. Short selling is taxable like interest income (or like you salary from work). Normal purchase and sale of stock is taxable as capital gains at roughly 50% of the tax rate of interest income.

4. Brokerages can see short selling activity and can either support it or hinder it. You cannot hope to win against the market makers, so again you need to find a way to trade with them (level 2 quotes maybe?).


#1 tip for short selling is don't do it. However, if you do, make sure you are right.

Max
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What do is you take on options?

Post  Vaughn on Wed Nov 10, 2010 11:29 pm

Yeah, shorty seems to be involved and for experienced traders.

What do you think about option trading? Calls and Puts that could leverage your funds while minimizing possible loss.

A thought or two

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Re: Short Selling Mechanics

Post  Max on Sat Nov 13, 2010 11:32 am

I wrote this about options previously. To be honest, I don't have much experience with them, so this is an academic discussion only. If you or anyone else has soem strategies brewing for options, go ahead and post it and I will give my opinion. For me, there is too much certain loss vs. potential gain in naked put or call options.


Basic idea is to trade the profit from the stock without investing all working capital into the price of the stock itself. You buy the "option" to purchase a stock (call option), or the option to sell a stock (put option) at a specified price.

Therefore, with $10,000, you could afford 100 shares of a stock trading for $100 or you could buy 1000 options for $10 each (random price for example purposes). If the stock goes up $10, your profits from owning the stock would only be $1,000 (100 x $10), while your profits from the options would be $10,000 (1000 x $10).

The thing to keep in mind about options is that if the stock trades in the opposite direction of your option, your option is worthless and you have 100% loss. Tempting to think that you downside risk is limited only to your investment, but in the case of put options, the stock price can rise indefinitely, and your losses are theoretically unlimited. Add to this the huge commissions and spreads in the bid-ask prices, and you have a very expensive and high stakes investment, and it is very hard to make enough profit to cover these costs.

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Re: Short Selling Mechanics

Post  lukera on Mon Dec 13, 2010 10:37 pm

Max,

I read up on short selling briefly today and knew that you had written about it here.

I have been scanning through many companies lately trying to come up with a winner but it seems like most of them are way overpriced for what the company is worth.

In this case would it not make more sense to sell short on a company that seems grossly over valued if it is easier to find this scenario?

Mining companies for instance seem to always peak following some really great drill results only to settle back down to just above the original price before the news. wouldn't this be a good time to sell short?

Most importantly I was wondering why you mentioned that brokerages don't support short selling? Is this not a good thing to do?
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Re: Short Selling Mechanics

Post  Max on Tue Dec 14, 2010 12:23 am

Not that brokerages don't support short selling. More that brokerages, institutions, and large individuals/groups control short selling. Control is exercised through the news. Negative spin is put on news, and stock prices go down. Positive spin and stock prices go up. It can even be the same piece of news spun both ways.

If you are shorting base on your analysis (or gut), and the insiders are going in the other direction, you are going to get hurt. It would be fine if you could hold your position forever and wait for rationality to bring the stock price back down, but you have to pay a steep interest cost every day you short a stock, and this eats into profits. Also, profits on short selling are taxable at twice the rate of a capital gain, so you lose there too. You probably have higher trading commission on this kind of specialty trade as well.

With these factors adding up, short selling is taking on a lot of guaranteed loss for the expected return. Also, there is a floor on the price of around book value, and theoretically no cap, so again, the odds are not stacked in your favour.

I think put options would be safer and more profitable, but I am no expert on options either (although I am slowly studying).


Anyway, I think you are on to something in your inability to find bargains. I am having trouble with this too lately, which is a sign that the market is indeed overpriced and due for another correction. If retail sales during Christmas are softer than expected, and merchants have to discount the hell out of everything during boxing week, then profits will suffer, and I think you will see the news begin to turn negative. Newsmakers are looking for a catalyst to move stocks in the direction they want them to go. Looking at the S&P index, with an average pre-crash value of between 13,000 - 14,000, and a current value of 13,295, and given the current economic instability, I don't consider it reasonable for stocks to be priced this high. You will see positive news before Christmas that a recovery is coming, ("spending is up vs. 2008") giving insiders time to dump their shares at the highest prices possible, then the negative spin will come out ("spending is down vs. 2007", "retail numbers are a barometer for the economy") in order to drive down the price so they can buy them back cheap later.

I would be careful, but I still wouldn't short anything. I am tempted to set up options trading and buy put options on the S&P, but timing the top is just as difficult as timing the bottom. Options have an expiry date to consider, and I am notoriously early to sound the alarm, and will likewise sound the all clear and jump back in the water just as the shark appears.

Probably, I am better off in cash, and waiting for bargains.

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Re: Short Selling Mechanics

Post  lukera on Tue Dec 14, 2010 7:27 am

That makes sense to me.

Probably, I am better off in cash, and waiting for bargains.
What you said here strikes a chord with me. I am quickly realising that patience is definatly a virtue. one i need to work on Wink
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