Short Selling Stocks: A Viable Option

Like many investors out there, market volatility has caused you to rethink your investment strategy. The classic buy and hold strategy works well-until it doesn’t. First, there was the technology bubble of 2000. Then the bottom fell out and the tech-heavy NASDAQ dropped 83% in just over two years. Then there was the financial crisis. Remember when real estate couldn’t go down? Financial companies holding mortgage and other asset-backed securities almost imploded. Some did. Short selling stocks are one way to hedge your portfolio against a market decline. But it’s not for everyone. First, a quick refresher on the short selling stocks.

Short Selling Stocks

Short selling stocks is a tactical strategy when an investor believes he sees an overpriced security or simply wants to hedge a portfolio of stocks against an overall market decline. It involves borrowing the shares of a stock you don’t own (but one you believe is overvalued) and selling it into the marketplace. You eventually have to buy the stock back in the open market and return it to the owner. In this instance, you are trying to sell high and buy low (as opposed to the old adage, ‘buy low and sell high’).

Short selling offers a way for certain market participants to make profits even when stocks go down. For example, if you can borrow and sell short the shares at $100 and cover (buy back and return) at $50, you’ve made a $50 profit (a 50% return) while most investors got clobbered holding their shares. This example is minus any fees or dividends, depending on how long the shares were borrowed for. Another benefit of short selling is the ability to raise cash in a down market (since you’re fronted the proceeds).

Some Rules When Short Selling Stocks

Margin Accounts

Short selling stocks must be done in a margin account. In a margin account the client can borrow money (i.e. use leverage) provided by the broker or custodian. The buyer has to put up just 50% of the market value of the securities purchased under current Regulation T requirements from the SEC. The remaining balance is a margin loan. Everything is fine if the stocks move in your favor but if they move against you, more money is needed. A ‘margin call’ on a short occurs when there is a significant paper loss in an account, causing the custodian to demand more capital so the amount borrowed doesn’t exceed 50% of the initial value of the short.1

This differs from a basic ‘cash account’ where the only amount you can use to borrow is the exact dollar amount in there (less the commission). There are borrowed funds available in this type of account from the brokerage house or custodian, so short selling stocks is not an option.

No Shorting in IRAs

Short selling is not allowed in Individual Retirement Accounts, or IRAs, since the Internal Revenue Service doesn’t allow any form of borrowing in an IRA. But this doesn’t preclude you from selling short in a traditional (non-retirement) brokerage account (assuming it’s a marginable account).

Another aspect deals with suitability. If you are a risk adverse investor, or a retiree it may not make sense to engage in short selling stocks. In fact, if you have a broker, they may not let you given their fiduciary duty rules.

Risks for Short Selling Stocks

When you buy a stock, you know the most you can lose is the money you put up (i.e. the stock goes to zero). But here’s the main difference when short selling stocks- your losses are theoretically unlimited. You could sell a stock and the stock could perpetually rise endlessly, splitting shares along the way. If you don’t think so, look at some charts of Priceline or Amazon.

Realistically, in such a disastrous scenario, you will be forced to cover the short (buy the shares back and return to satisfy the “lender”, often a major brokerage house) as the stock moves up. If you don’t do it, the broker will step in and do it for you, known as a buy-in, at a time of their choosing (whether you felt it was ‘the right time’ to cover the short or not). Conversely, you may have to deposit money for a margin call.

For one, if you plan on staying short the stock for a significant amount of time until your bear thesis plays out; you are subject to dividend risk. This means, that if the company pays dividends (or initiates a dividend policy while you are short) you ‘owe’ the dividend paid to the firm you borrowed the stock from. It will be deducted automatically from your proceeds.  With the amount of institutional ‘activist investors’ in the market today, this remains a significant risk for short sellers, especially if the activist perceives the company to be hoarding cash (that they feel belongs to shareholders via dividends). Technically, if you are short the shares as of the market’s close on the night before the ex-dividend date, you will owe the dividend.

There is also a spinoff risk which arises if the underlying stock you’ve shorted has a spin off or some type of divestiture. You could end up being short multiple securities, which could be problematic to try and cover. An example would be if you shorted Altria before they decided to spin off Kraft (you’d be short both).2

Finally, even when you want to short a stock, you may not be able to under SEC rules following the financial crisis. If a stock trades down more than 10% from the prior day’s price, a circuit breaker (essentially a temporary halt to trading in that stock; a ‘time out’ if you will) will go into effect. Short sellers will have to ‘get in line’ and can sell shares only after all attempting long sellers have finished.3

Rates for Short Selling Stocks

There are fees associated with this and other types of bear market strategies. Further, certain stocks may be classified by a brokerage house as “hard to borrow”, meaning they will hit you with an extra charge for the “loan” of the shares. This can range between a few percentage points to more than the full value of the shorted stock!4 The rate at some firms may be quoted as a monthly figure so make sure you know the annual rate to get an idea of what you’re paying. Any significant rise in rates is typically accompanied by a notice from your broker. At TradeKing, that amount is 3%.5 You can expect borrowing rates to rise with rising interest rates. You should always shop around or have an account with a few different discount brokers to compare rates.

Short Selling Disasters

I’ll always remember something I read in Peter Lynch’s classic book, ‘One Up On Wall Street’, about a short that turned into an absolute nightmare. Lynch retold the story of Robert Wilson, who shorted the stock of Resorts International. It was a penny stock at the time, about 70 cents per share, so while the company’s fundamentals may have been poor, the stock apparently already reflected this. Reportedly, Wilson went short at 70 cents and watched as the stock climbed to $70, a 100X price increase, costing him somewhere between $20 million and $30 million according to the book (page 275). It has also been reported by Forbes that Wilson shorted Resorts at $15 and watched it go to $190 in a few months but the point about the trade is the same, he got clobbered and lost millions of dollars.6

Robert Wilson, a generous philanthropist, was actually one of the first hedge fund managers on Wall Street, starting Wilson & Associates in 1969. The interesting thing about this particular loss was that he was using it as a hedge against his existing [long] portfolio of stocks. So even with the short selling debacle, Mr. Wilson reportedly returned a positive year overall in his fund of 25% in 1978.7

A Final Word on Short Selling Stocks

Some people believe that short selling stocks is somehow unpatriotic or against the spirit of the stock market. Successful ones get vilified in the press during market sell-offs and are even blamed for their occurrence. We believe that shorting stocks plays an important role in keeping the stock market in equilibrium and adds liquidity during volatile times. Even SEC Chairwoman Mary Shapiro revealed that “short selling can potentially have both a beneficial and harmful impact on the market.”8 Just as buying and selling stocks [long] can in our opinion.

When considering short selling stocks, it might make sense to enlist the help of a professional money manager who has the time and ability to watch over this, and other bear market strategies, like a hawk. The manager may apply a combination of different strategies including short selling stocks, buying protective put options, inverse ETFs, alternative exchange traded funds (including risk parity and low-volatility funds) as well as utilizing managed futures contracts. It never hurts to at least get some information on the money manager and see how they can help hedge your portfolio, while allowing you to not have to be tied to your trading screen every second of the day.

Of course, each strategy should be compared and evaluated based on your personal financial situation and risk profile because each has unique pros and cons. We expect a number of managers to begin to adopt this ‘hedged’ approach to money management going forward, especially if what we believe is looming for equity markets comes to pass.

Finally, you can always just raise cash to protect your portfolio (you probably won’t need a money manager for that, although it makes sense to research even the safe ‘cash’ money market funds out there). Some believe U.S. Treasury-Only money market funds are among the safer options because they may not involve repurchase agreements and other yield enhancing schemes). The yield is lower for Treasury-Only funds but if the point is safety you’re after, that shouldn’t be an issue.