there's increasing anxiety> among many analysts and investors that an autumn drop in stocks is only inevitable. The question is: Does "shorting" stocks, the typical move for downbeat investors, make sense right now?
Most investors know that going short involves betting that a stock s price will fall -- not wearing high hemlines (although both moves, it could be said, require a certain daring). But what does shorting actually entail, and is it something you should try on a regular basis?
Shorting involves borrowing shares of a stock and selling them, hoping to buy them back later at a lower price and pocketing the difference. Traders already have begun making bets against stocks again. Many experts believe the market is overvalued and due for some sort of a pullback. In August the number of shares sold short in stocks on the New York Stock Exchange rose slightly from July. But investors short stocks for a variety of reasons. Some of those who short opportunistically hope that a stock will go all the way to zero. Last year, short sellers piled into stocks of financial and real estate companies, some of the most vulnerable in the economic downturn. Today, names like Citigroup (C)
Experts say investors can also short stocks to hedge, or mitigate, the risk in their portfolio. Say you want to invest in a sector undergoing a major transition, like health care. An investor can buy the stocks ( going long in trader lingo) that he or she thinks will best weather the changes and sell short those with a murkier outlook. (Pfizer (PFE)
Shorting stocks, by nature, is controversial. For one thing, company executives are not fans of investors who short their company s stock en masse. John Thain, the former head of Merrill Lynch, blamed short sellers for the rapid deterioration of his firm s fortunes last year. It s also been blamed for exacerbating the financial crisis. During the peak of the crisis last fall, the government imposed temporary limits on short selling, not allowing shorting in certain financial stocks.
To short, investors need what s known as a margin account (the term margin refers to borrowing). Some do-it-yourself brokerages, like Charles Schwab and Fidelity, require a minimum of $5,000 to trade on margin. When an investor shorts a stock, he borrows its shares from his or her broker and then sells them. (The investor doesn t actually have to find a buyer the entire transaction happens with a click of the mouse.) The investor s account is credited with the proceeds of the stock sale. This isn t free money, though investors need to keep cash in their accounts in case the price of the stock rises and they need to buy back the shares. When investors buy the shorted shares back, it s called covering the short, and investors always are on the hook for the number of shares they borrowed. If the stock rises but the shorter thinks it will eventually drop and wants to keep shorting, he or she might have to add more money to his account to cover greater potential losses. When brokers ask for more collateral like this, it s known as a margin call.
Shorting requires vigilance and a high tolerance for risk, analysts say. If you do any of it wrong, the cost is high, says Rick Lake, co-chairman of Lake Partners, an investment management firm. There are three dangers short sellers face that most ordinary stock buyers don t.
The Margin Call
Shorting a stock requires borrowing money. A brokerage often will happily loan an investor money, but if the shorted stock rises in value significantly, the brokerage will want the investor to add more cash to the account or sell some other stocks to compensate.
If an investor buys a stock and it falls to zero, all the investor loses is the initial money he or she paid. After all, the stock can t go below zero. But on a shorted stock, there is, in theory, no limit to how much money an investor could lose, since a stock could keep rising and rising.
If an investor owns a share and the value goes down, he or she can always be patient and wait for the stock to rise. A short seller doesn t have that option. If the stock price rises, the short seller might be forced to buy it back quickly. When many short sellers try to buy shares back at once, the stock s price can zoom higher, creating a short squeeze, and short sellers can lose a lot of money very quickly.
For investors who want access to the strategy without executing it themselves, experts suggest buying a mutual fund that shorts, like Federated Prudent Bear, or a short ETF like ProShares Short S&P 500, which seeks daily investment performance that s opposite that of the S&P 500 broad market index. The short ETF was up more than 39% last year, but down almost 17% this year.