A “short sale” refers to selling stock that you do not own with the hope of repurchasing it at a lower price later. It is a way for an investor to try and profit from their view that a particular investment is overvalued and likely to fall in price. This technique can be used on individual stocks, or on Exchange Traded Funds (“ETFs”) that represent anything from individual sectors to the overall market. While there are many successful investors who have done well on the short side, for most people this strategy doesn’t make a lot of sense due to the risks involved.
The mechanics of a short sale are as follows: An investor goes to their broker, borrows shares of a stock and sells them. The short sale proceeds are credited to the short seller’s account, less a fee for borrowing the stock. You must have a margin account in order to short stock. If the price of the shorted stock rises, the short seller will need eventually to borrow on margin to keep the position open.
The short seller receives interest on the short sale proceeds, although this is minimal currently since interest rates are low. In practice, this interest is often split with the buyer of the shares or the brokerage firm that is facilitating the short sale. The short seller must pay any dividends on the borrowed stock to the purchaser of the shares.
Risks of Short Selling:
Swimming Against the Tide –Since 1926, about 7 out of 10 years have been positive for the overall market. If you are short the overall market, chances are you will be in a losing position after a year.
Timing is Critical—Stocks can move quickly in either direction, and it is difficult to predict the future. If the event that you are betting on fails to materialize, or if the opposite happens, your losses can mount quickly. For this reason, short selling is more common among professional and institutional investors.
It can be Expensive to Maintain a Short Position— With today’s low interest rates, the combination of the borrowing cost and the dividends the short must pay to the long far outweighs the interest on the short sale proceeds that the seller is earning. For example, say you short 100 shares on Johnson and Johnson at $108 because you think Band-Aid sales are going to decline sharply. You receive proceeds of $10,800 and earn money market interest at 0.01%, or $10.80 per year. Your annual cost to carry the position is the 2.8% dividend, or $302.40 plus any borrowing costs charged by your broker. These additional costs can be quite high for stocks that are hard to borrow.
Limited Profits but Potentially Unlimited Losses–At most, any stock can go down 100% in value. However, there is no limit to how far a stock or the overall market can go up. If it goes up by enough to wipe out the equity in your margin account, the brokerage firm will buy-in the security at a loss and close the trade. Say you short a stock at $8/share. The most you can make is $8 if the company goes out of business and you are able to buy back the borrowed shares at $0. But what if good news comes out and the stock goes from $8 to $18? You just lost $10/share when your maximum theoretical profit was $8. In reality, few companies go out of business so your maximum profit is even more limited.
We believe that, rather than trying to profit on short-term price movements, our clients should place the equity portion of their investments in a diversified portfolio of quality companies with the potential for rising earnings and rising dividend income.
Bill Hansen, CFA