HOW SHORT SELLING WORKS?

The process of stocks short selling consists of the following: The investor borrows shares of the stock they are going to short from his broker. This step is accomplished using "cash on deposit" at brokerage firm that can be used as collateral. So when an investor borrows stock, they're promising to give back the stock at a future point in time. The stock you borrowed is then sold at the market, and the cash from that transaction is paid in your brokerage account. You (investor) then wait for a decline in price, if there is any, and after the price goes form 15$ to 10$, you close a position by buying back the shares. This is what is called covering a short position. The investor returns the borrowed shares back to their broker or lender.

EXAMPLE OF HOW IT WORKS:

Let's say that you believe that ABC Company Inc. stock is due to fall, you then calls your broker to sell short 1000 shares of the company. Also, let's assume that your trade is immediately executed, to sell short 1000 shares of Company Inc. at $30.00 per share. You will receive a cash inflow of $30,000 from this transaction.
 

In four weeks later, the price has indeed dropped, and you are able to buy back the shares (also known as covering a short position) for $20.00 per share. In this transaction, you will spend $20,000 to buy shares that you need to cover your position. Your profit on the trade will be $10,000 ($30,000 minus $20,000). If stocks had risen to $35.00 during the time position was opened, then he would have a loss of $5,000 (1000 shares x $5.00/share).

RISK OF SHORT SELLING STOCKS:

Short seller is still trying to do the same thing a regular investor is, and that is to buy low and sell high. But the short seller is trying to do this in reverse order. He is trying to first sell high and then buy low. The short sales strategy, which is the opposite of entering a long position, is a risky one for a several reasons. These include the potential for a margin call, and theoretically unlimited losses if stock price rise, since the price of a stock cannot fall below $0 per share, the upper limit for profit is the total value of the stock sold short.

OTHER IMPORTANT THINGS TO KNOW EVEN IF YOU DO NOT SHORT SELL STOCKS:

Short interest is a measure of the total share volume that is currently short the stock. When a person short sells, the order must be identified as a short sale and these statistics are kept for each stock by the exchange. Short interest can be a source of demand if buyers become enthusiastic for the stock and price rises prompting some short sellers to reduce risk by buying back stock to replace and closing the short position.

A high short interest ratio is considered bullish while a low ratio is considered bearish. A ratio of 2 is considered 2 days potential buying power. In some future posts, when I'll write more about investment strategies, and what does work and what don't, you will se that actually, low short interest ration is a bullish sign!!! But more about that later.

The short interest ratio is called a contrary opinion indicator because an increase in short selling is an indication of a strong potential demand element as short sellers are likely to close positions quickly if the market price proves them wrong.

Odd lot short sales has been considered a measure of uninformed investors and was used by investors to give evidence of market bottoms as late comers to the market were considered uninformed. Now it's not widely used.

Specialists short sales are also available as a data source for measuring short selling. This is considered the smart money. Often investors watch the ratio of specialists short sales to total number of short sales to give an indication if the smart money is bullish or bearish. A short sell can be used as part of a bullish strategy as so can skew the basis for interpreting the ratio.

That's all for today.

WHAT IS SHORT SELLING AND HOW CAN I BENEFIT FROM IT?

Traditionally people understand investing in stocks in way that you buy an stock and hold it until it rises enough to make a sizable profit, and sell it after that. But what about the times you come across a stock that you wouldn't invest in, and you think that it is only a matter of time when it will collapse? Well you can profit from the decline of a stock and although it sounds easy, the mechanics of a short sale are little complicated and the investor's risks are high so it is important that you understand the transaction before getting into it.

PROCESS OF SHORT SELLING:

First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. Short selling is the selling of a stock that the seller doesn't own, so it’s the sale of a security that isn't owned by the seller, but that is promised to be delivered. When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must close the position by buying back the same number of shares and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money. So the risk is that stock prices can theoretically rise indefinitely but fall down only to zero.

So short selling or "shorting" or "going short" is the practice of selling assets, such as stock, futures, options etc. that have been borrowed from a third party ie. a broker, and buying identical assets back at a later date to return it to whom lend it to you. In other words, you take a "negative" position in the market, because you bought a negative amount of assets. If you short a stock, you expect price to fall to profit form your position, and to be able to buy back the shares you nee to close a position, at a lover price that you paid for. So going short is a contrast of going long.

WHERE DOES BROKER GET THE STOCKS?

Short selling is a marginable transaction. You must open a margin account to sell short. This is the same account you would use if you want to use your stocks as collateral to by stock on margin (more about that in the future posts). The general rule is that the value of your portfolio must equal at least 50% of the size of the short sale transaction, so if you have $25,000 worth of stock/cash in your margin account, you can borrow $50,000 of stock to sell short.

HOW DO I SELL SHORT?

Short selling, unlike a normal stock transaction where we have buyer and a seller, here we have the original owner, the short seller, and the new buyer. Short seller borrows shares from the original owner, and then sells them on the open market to any willing buyer. To close his position, he (short seller) must buy the same amount of shares as he sold so that the broker can return them to the original owner.

While you have an open short sale position, your broker will charge you overnight interest on the value of the short position. If the stock you shorted goes up or down in price your collateral will be higher or lower, and if it is lower by certain amount you may be required to place more money in your brokerage account, or buy back the stock that you sold short. Also, you must pay any dividends issued by the company whose stock you sold short, because that person is still the real owner of the shares you hold.

WHY SELL SHORT? SPECULATION AND PORTFOLIO PROTECTION:

The two primary reasons for selling short are speculation and and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level, and they believe that the stock price will fall. A short sale provides the opportunity to profit from the overpriced stock.

Another reason is that short sales can protect your portfolio against a market downturn. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling. This is know as a hedging. More about that I'll caver in future posts.

STOCK BUYBACKS: GOOD, BAD AND THE UGLY

Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

OVERALL GROWTH ISN'T IMPORTANT AS  GROWTH PER SHARE:

Here is an example of ABC Company Inc:

Stock price is  $50 per share. There are 100000 shares outstanding. Market Capitalization is $5.000.000.Profit made this year is 1 million dollars.

So in this example, each share equals .001% of ownership in the company, which is 100% divided by 100000 shares. If the management see that their company (business) will have the same amount of profit this year, like it was last year, that means that their growth rate is 0%. Because the management want to improve the picture and show to shareholders that they are good management, they come up with the idea of stock buybacks. The company use 1 million dollar profit to buy back it's shares on the open market.

After the buyback, as we learned in previous posts, those shares are owned by the ABC Company Inc. and removed form circulation. Now there are only 80000 shares outstanding instead of 100000 that were originally issued.

Average investor (aka shareholder) now no longer have  0.001% of the company, but 0.00125%. In percentage term it is rise of 25% in one year per share!. After the buy back, stock rise will rise in price to 62.50$ from 50.00$! So even though the company made the same amount of profit this year like it did last year, stock price rose 25%!!! Average investors are happy.


WHEN NUMBER OF SHARES OUTSTANDING ARE REDUCED, EACH OF SHARES IS MORE VALUABLE AND MEANS GREATER PERCENTAGE BUSINESS OWNERSHIP:

If a management, like in above example, is in charge, this can lead that amount of shares outstanding goes to 50 or 100. So it good to hold companies like one in the example, buy only if they are fundamentally strong, and hold it in your portfolio as long as they keep doing buybacks. This can increase your profits, but as I said, this destroys companies balance sheet and it's not good long term. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years.


IF MANAGEMENT BUYBACK SHARES AT HIGH PRICES, BUYBACKS ARE NOT A GOOD THING TO DO!

Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually bad if a company pays more for its stock than it is worth or uses money it cannot afford to spend ie. Borrow the money. If the market is overpriced it is bad decision for management to buyback stocks. Instead, the company should put the money into assets that can be easily converted back into cash, to improve liquidity. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit.

There is a saying: "Even the best investment in the world isn't a good investment if you pay too much for it".

What Is A Dividend?

The word "dividend" comes from the Latin word "dividendum" meaning a thing to be divide. The definition of a dividend as it relates to finance is:

1. A pro-rata share in an amount to be distributed
2. A sum of money paid to shareholders of a corporation out of earnings
 

An investor who is holding common stock ie. ordinary shares in a company will receive a return in one of two ways: capital gains which come from price changes and dividends. They are payments made by a corporation as a portion of corporate profits. When a corporation earns a profit, that money can be re-invested in the business which is called retained earnings , or can be paid to the shareholders as a dividend. Usually, corporations retain a portion of their earnings and pay the remainder as a dividend.
 

There are practical limitations to a company paying out a dividend. A firm must have distributable reserves on the balance sheet to be able to pay a dividend. A company may therefore dip into the undistributed profits of previous years.
 

A firm also must have the cash available to pay out. Any experienced investor will know that profits do not necessarily mean cash, because a company can have last year's profits but negative cash flow, and that means problems to pay dividend to it shareholders.
 

But when company once start to pay dividends, it is difficult for them to stop, because their dividends acctracted some mutual funds that select their investments partly on dividend policy and history of a company, and missing one or more payments can lead to funds selling their holdings. These sales can lead to an imbalance in the supply and demand of stock and a fall in the price in the market.