What everyone needs to know about shorting stocks

The great stock speculator, Jesse Livermore, was known primarily as a short seller of stocks. He was even blamed by some for the stock market crash of 1929. While he made money shorting stocks (thus profiting when their prices decreased), he also speculated on the long side as well. His story is a great story, and he has many tips that are useful even for people who do not share his extreme risk-seeking behavior.

I highly recommend Edwin Lefevre’s fictionalized account of Livermore’s first two decades in the market, Reminiscences of a Stock Operator. Of course, we would all be wise to remember that there is much more to life than the market. Livermore committed suicide in 1940; his suicide note read: “My whole life has been a failure.”

I do not think shorting stocks is a good idea for most people. It is very easy to quickly lose a lot of money shorting stocks. However, shorts can tell us a lot, and it behooves us to understand and pay attention to stock shorting.

First, let’s start with a simple definition: shorting a stock involves borrowing that stock from someone who owns it and immediately selling it, with the promise to buy back that stock in the future. Someone who is short a stock makes money if the stock decreases in price.

Why would anyone go short? If a stock is highly overvalued, or a company is run by complete idiots or a kleptomaniacal management, it would be wise to go short and benefit from the stock eventually falling. However, shorting a stock exposes you to infinite risk–if the stock more than doubles, you will lose more money than you invested. Going long, on the other hand, is much less risky, since you can only lose the money that you originally invested. Another problem with shorting is timing: for example, look at the chart for Cheniere Energy (LNG). Cheniere has not yet made any money from its main business, liquefied natural gas receiving terminals, and there is a significant risk of the company going bankrupt before it ever makes money. But with the increase in natural gas prices, the stock price shot up drastically in 2004. This led to a number of people shorting the stock, and they made plenty of money as the stock fell below $28 (from a high of $40).

Since that time, however, Cheniere’s stock has gradually bounced around, bringing it back up to its previous highs (and back below again). All that happened despite no fundamental changes in Cheniere’s outlook. Another interesting company has been Overstock.com (OSTK). While shorts have made money in this stock over the last year, and the company still looks overvalued, there is no reason the stock price could not shoot up again, giving the shorts some huge losses.

One last problem with shorting is that it requires betting against the long-term trend of the market. Over time, most companies become more profitable, and the U.S. economy as a whole grows at about the rate of 3.5% each year if we subtract inflation. If we figure in an average inflation rate of about 4% per year, then we add those two rates together with the average dividend rate (historically) of about 2.5% to get the average growth in stock prices per year: about 10%. In the long run, shorts will lose. In the short run, however, the market is far from perfect, and a savvy short can profit.

Just for your information, there is another way to profit via a stock’s declining price. That is via the use of put options. They have the benefit of reducing risk to the amount used to purchase the put, while also increasing leverage. On the other hand, options have a limited lifespan, so if you buy an October put and the stock doesn’t decline until November, then your put will expire worthless.

So why do people short sell? There are several different strategies to short selling. The classic hedging or market-neutral strategy involves buying the stocks of good companies in an industry and then selling short the bad companies. This same strategy can be used with all stocks in the market–buying the best and selling the worst. This way, a money manager can make profits even if the market as a whole does not go up. An astute manager would be net short (have more short than long positions) if he thought that the market should decline, and be net long if he though the market should go up.

Others, who sell options, may wish to short a stock so that their market risk is neutralized. A seller of call options would short the underlying stock to remain market-neutral, whereas a seller of puts would buy the stock. Other investors (including hedge funds and mutual funds) may choose to short sell some stocks as a kind of insurance for their (much larger) long positions.

So, anyway, to the main point of this article: why should everyone know about shorting? Simply put, short sellers tend to be the most sophisticated investors and speculators; many hedge funds use short-selling strategies. The short interest ratio is easily available for most stocks, and we can find it for free at Yahoo Finance. For example, see the short ratio of XJT (it is under share statistics). It is currently at 29%. For most companies, the short percentage will be well under 1% (such as for GE). Besides using Yahoo Finance, you can also find short interest from E*Trade (even if you are not a customer); they report the last four months of short interest. For Nasdaq stocks, visit the Nasdaq website to find the number of shares short for a given stock.

For comparison, check out the short ratios of GM (11%) and British Petroleum (BP) (.1%). So how reliable and how useful are short ratios? For any one stock, they are not a very reliable indicator of how the company is doing or where the stock will go. In general, however, stocks of companies with high short ratios (over 2.5%) tend to do worse than stocks of companies with low short ratios. If you wish to read further, I suggest the following article: Short-sellers, Fundamental Analysis and Stock Returns, by Dechow, Hutton Meulbroek, and Sloan.

A stock will tend to do poorly if it is overpriced or if the underlying company is doing poorly. Thus, short ratios will tell us whether some sophisticated investors think a company is doing poorly or if its stock is overvalued. If we are buying too many stocks with high short ratios, we are probably doing things wrong. It is important to remember that as value investors, we will often buy stocks selling at lows. These stocks may have been overpriced or fairly priced, but they would by definition be great candidates for shorting. Therefore, it does not surprise me if a stock I find attractive has a high short ratio.

What is important is that as the stock decreases in price and becomes a better value, the short ratio should decrease. So if I am tracking a stock that goes from having a 15% short ratio to a 5% short ratio, then there are a number of sophisticated investors who believe that the stock is no longer overvalued. Conversely, if a stock has a short ratio that is increasing considerably, we should be wary about any problems that the company may be having.

If you are interested in how short interest relates to the market as a whole, I suggest the academic paper by Lamont and Stein: Aggregate Short Interest and Market Valuations. The punchline is shown by the figure at the end of the paper: short interest does not really tell us that much. If anything, a low overall short interest level indicates stock market losses and a high level predicts stock market gains!

Disclosure: I hold no shares (long or short) of any of the companies mentioned in this article. See the disclosure policy.

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