The Basics of Shorting Stocks

IN 1977, POP MUSICIAN RANDY NEWMAN released a surprise hit song entitled “Short People.” In the lyrics for this satirical novelty song, Mr. Newman lists the flaws and “shortcomings” of the smallest of our fellow men. The song focuses on a repeating chorus of “Short people got no reason, no reason to live.”

As could be expected, many of the vertically challenged among us took great offense to the theme and insults of this song. Newman has maintained that the song was written for irony’s sake, yet he has still lost some big supporters who happened to come in small packages.

Now more than 30 years later, people are getting back at Randy Newman. We are seeing short people cropping up everywhere these days, and not just the ones shopping at GapKids.

Investors, many very successful, are increasingly becoming short people, and anyone can do it. In the investment world, physical attributes seldom play a major role in the success of an individual. Even the smallest investors can have big success if they focus on the right markets and make the right plays.

That’s why now even someone as tall as Yao Ming can be a successful short person. All you have to do is have an eye for what will work, but especially an eye for what won’t.

Choosing a stock that is poised to rise is a fundamental part of investing. It is something we are taught immediately when we learn about stock markets and the financial industry. But of course, that is only part of the game. Seeing something that will go down can be just as lucrative, if not more so. This is what is known as “shorting.”

The practice of selling something short can sometimes be difficult, but the thought process behind it is actually quite simple. When you short a stock, you are basically just betting that the price will soon go down. Like all good investments, it does take a lot of skill and some luck to really be a success, but it certainly offers you a terrific play to make when the markets are in decline.

If you want to short a stock, the first thing you do is contact your broker. Let’s say that you think the value for Stock X is far too high and it will soon go down. For example, let’s imagine that Stock X is currently priced at $50. You tell your broker that you’d like to short 100 shares of Stock X at its current price.

What happens now is your broker will go out and borrow 100 shares of Stock X from his own inventory or from another brokerage, with the guarantee that the shares will be returned at a specific time. Of course, you will have to pay interest on that borrowing, but that is where the relationship with any other brokerage ends.

Now your broker takes those 100 shares and sells them for $50 dollars each. You now have $5,000 dollars in your account that you have borrowed and will need to pay interest on. If you decide to short this stock for April 2008, that money will sit in your account until that date waiting to buy those shares back.

This is the time when your heart rate may increase a few beats per minute. You may notice some excess sweat on your brow as you wait for your short date to arrive. If you are wrong and the stock price actually goes up, you will wind up paying more money to repurchase the shares than you originally could have in originally.

But if you have made a wise decision, you won’t have to. For our example, we’ll imagine that the price of Stock X has fallen, and fallen considerably. The price is now $30, instead of the original $50. This is a sharp decline, but nothing we haven’t seen before. Your April short date finally arrives, and you are now permitted to exhale. Your short option was a success, and now your broker will gladly repurchase those same 100 shares for the much-discounted price of $30.

The shares are repaid to the broker’s inventory or separate brokerage house without any explanation or report necessary. Your account now has a balance of $2,000 left, and that’s all yours. Well, you’ll, of course, pay a commission to your broker, but you get the idea. Your gamble paid off, and you are now $2,000 richer.

When to Short

The story of Stock X is a simplified and ideal example of shorting. First of all, I was fairly certain the example was going to work out while I was writing it. Second, Stock X exists in an imaginary sector of the market. Those are the easiest to predict. In real life, things get more complicated, but they are still quite manageable.

Finding which stocks to short will take some practice and may not be for beginning investors. But if you have some experience with investing and can see which way the winds are blowing, you are already ahead of the game.

First, pick a company that may be going through some turmoil or management trouble. You may be able to predict that this company will lose value. You can be especially confident if that company exists in a segment of the market that is also in trouble. The combination of bad management and a downturn for the entire industry often leads to incredible short gains.

Think of a once-successful company in the retail garment industry. Maybe this company is in the midst of figuring out where it fits in the market. Its sales have gone down recently and the people at the top have still not figured out how to salvage the business model. This looks like the kind of company you could short, but there is still a big risk. What if management figures it out and the stock shoots way up overnight? You would be left out to dry because of that unforeseeable event.

This is where you have to do some thinking. If you look at the retail industry right now, you can see that it is a troubled market. Lackluster sales in November and December, when the retailers need sales the most, have given people a very dour forecast for retail markets in 2008. Now you have your two ingredients.

You have a struggling company still living off of past reputation that does not yet fit with a changing world. You have a market segment struggling as a whole and desperately searching for a way to rebound. This is the kind of company you can short, and feel pretty confident in doing it.

Now that you know all the tools to become a short person, you can finally be a winner simply by identifying losers. Get out there and stand tall as a successful short person. Randy Newman may not think so, but short people have plenty of reasons to live, and live well.

Until next time,
Jamie Ellis
January 14, 2008