Stock markets have been on a long bull run with only a very few minor pullbacks since March 23, 2020. The government has provided a major amount of stimulus, and this activity will likely continue. But the day will come when the stimulus ends. What happens then? If history is any gauge, we can expect to see the Fed begin to wind down its bond and CDO purchases in the foreseeable future (tapering back quantitative easing). This alone should generate a pullback of some nature as it has in the past. The private investor’s remedy could be to offset declines in core stock investments with short sale gains done on a temporary basis.
What constitutes a short sale?: A short sale of securities takes place when the investor sells a block of stock that he/she does not own. To do this, the investor’s broker must borrow the stock on the investor’s behalf from another investor, usually from the broker’s own inventory. At the time of the short sale, the investor receives cash for selling the position and a debit on his statement showing that he has borrowed shares that must be returned. Done properly, the stock would go down in value and the investor can then buy the shares at the cheaper price to return them, covering the position at a discount and keeping the difference. The beauty of it is that the short position can generate a profit without tying up any additional capital.
Restrictions apply: To conduct a short sale, virtually all brokers have restrictions that will apply to the investor’s account. First and foremost a margin account is required. This type of brokerage account will enable the broker to borrow on the investor’s behalf, charging interest (known as short or margin interest) when applicable. Further, the investor must agree to permit the broker to unilaterally cash other securities in the portfolio to cover the short position. If the price of the stock climbs dramatically high, brokers require this permission to limit their risk exposure. The investor may reinvest the proceeds of a short sale, but interest as high as 8.5% will be charged if there is not enough cash in the account to cover the short position.
Tools needed: In addition to a margin account, the investor should have screening tools to enable him/her to find companies that are on losing streaks or having financial problems, in addition to the market impact of a downturn. The investor first should screen the Fortune 500 (for example) for stocks that are deteriorating or are considered short sale candidates. Next, run those stocks through a tool such as Charles Schwab’s Market Edge that applies a series of technical tests to attempt to predict the future trend of the stock’s price. From there a list of short sale candidates should be derived and then checked through a broker’s research machine for their underlying fundamentals. A short seller is looking for the opposite of what an investor buying a long position looks for when it comes to fundamentals—sales falling off, increasing debt, industry sector suffering, cash flow problems, rising costs, declining retained earnings, etc., etc., etc.
Short sale strategies: The best timing for a short sale could be when the stock market has topped out—not when it is already in decline or when it is on a bullish rally. When the market is riding high, Market Edge will show the strength of those stocks that are tapering off. A stock’s strength is determined by whether it is under accumulation or distribution. In the last fifty trading days, if the stock has more volume on the down days than on the up days, it is considered to be under distribution. The converse is true if it has more volume on the up days. The candidate list should be checked to see if the stocks are under distribution, but keep in mind that a candidate stock’s strength status could change on short notice. Short sales also mean short duration—strictly a timing mechanism for downturns and not necessarily a good acquire and hold strategy. An acquire and hold short sale strategy carries too many risks or complications for most private investors. Although shorter duration is preferred, the longer the pullback, the longer the duration.
Best practices: Best practices include exiting the short position anytime it moves adversely by 10%, as this will stop losses from getting out of control. As short selling should be done over a short duration, the timing of the entry point becomes critical. The proceeds of the short sale should be retained in the account until the short position is closed to avoid paying short interest. Doubling down on short positions that rise in price would bring up the seller’s breakeven point, but as a best practice this should be avoided as the overall risk is also increased. The short seller is responsible for providing the dividend to the real owner of the stock in the event the short sale trades ex-dividend. The best practice for this would be to avoid shorting stocks that have a dividend ex-date pending.
Risks: Every investment carries certain risks. A buy and hold long position has a limitation in that the maximum the investor could lose would be the amount of the investment and no more. A short sale has no limit to the loss the investor might receive. For example, by shorting 1000 shares of a stock at $10 per share, all the investor receives is $10,000, no more. But if the same stock goes up to $50 per share, the investor would have to pay $50,000 to buy the stock to cover the debit. As for stocks that are really in bad shape, remember that many other investors are likely already short those stocks, and short sellers might not be able to borrow the shares from the broker’s inventory. To remedy this, the broker might require the investor to provide up to $100,000 in additional funds in advance to get the broker to go into the market to find the shares to borrow. Another great risk is a short squeeze that occurs when the shorted stock takes a sudden run up, and large groups of short sellers all try to buy the shares needed to cover their own short positions. This action will cause the price of the stock to be bid up much higher, turning a good short position into a bad one.
Summary: Short selling is one way to offset the losses to an investor’s portfolio during a market pullback without requiring the investor to sell his/her core stocks. A series of small short sale positions carefully monitored can provide the investor some relief without requiring any additional capital, as some of the positions may wind up losing, but the majority could win thereby providing an overall gain. Short selling can continue until the pullback is over. At that time the investor closes all short positions and (hopefully) sits back on a stack of cash just earned.