Michael Shulman

Issues With Shorting Stocks

by Michael Shulman   08/09/08

Brokers are able to handle most shorting requests, although selling short is a little more complicated then going long and buying put options.

That being said, there are some major issues you need to understand before going short. Most of these relate to the actual shorting of a stock, not buying puts.

* Risk: In a long position, the most you can lose is 150% if you borrowed on margin to leverage your investment. With a short position involving the borrowing of the stock, your theoretical potential loss is unlimited. If you borrow a stock when it is trading at $10 and the stock runs up to $200, then you are out $190 a share -- 19 times your original investment! Not a good thing.

* The Margin Account: You need to open a margin account to short a stock. It is in this account that the funds from your sale of borrowed stock will be placed. But don't count on collecting interest on this money. Not only will the broker charge you interest on the shares you borrowed (unless you are Warren Buffett or the CEO's cousin), they will not pay you interest on the funds in the account or sweep it into a money market fund.

* Finding the Stock: You may want to short a stock that is hard to find. The process of finding shares is called a "locate." If your broker cannot find them, then you cannot short the stock. It is also virtually impossible to short a stock with a price under $5, and you cannot short a stock within a specified period from its IPO, depending on the exchange the stock trades on.

* Margin Calls: If the price of the stock you have shorted rises, your broker will ask you to put more funds in this account, typically enough to cover the purchase of the stock on the open market at the current price. If you don't make the payment asked for by your broker, and you have other securities held long in that margin account, the broker will sell those securities to meet the margin call.

* Early Sale: If the original owner decides to sell the stock, you must replace it -- either by finding other shares through your broker or buying it on the open market.

* The Short-Squeeze: You have probably heard this term more often than you care to remember. A short-squeeze is a market event when the price of a stock rises quickly, prompting shorts to "cover" -- which means they must buy the stock in the open market to repay the shares they have borrowed. This generates higher prices, which in turn prompts more people to sell and take a profit, which leads to brokers calling more loans, which then forces many short-sellers to go into the open market to cover their loans. And so on. Short-squeezes can be ferocious, can last quite a while and can be very expensive.

* Early Calls: In the United States, although call and put contracts have an expiration date, the transaction can happen at any time up until the expiration date. So, in theory, if you sell a covered call, the owner of the contract can buy the stock from you before the contract expires.

* Interest Payments: You will pay interest on the borrowed shares at the broker loan rate based on the price of the stock when you borrowed it.

* Dividends: If you have borrowed and shorted a dividend-paying stock, you will receive the dividends but you, in turn, must pay the original owner the value of those dividends.

* Taxes: Should you hold a short position for more than one year, well, tough luck -- the IRS still treats capital gains as short-term gains. Ah, Uncle Sam is always reliable!

I've spoken today about a lot of the issues about actually shorting a stock, but the real issue here is the level of risk you want to take on. A much lower-risk way of going on the "dark" side of a stock is to buy a put, and not borrow shares. Keep this in mind before you consider shorting a stock.

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If you enjoyed this article, check out Michael Shulman's "Short-Selling With Put Options 101" and "Making a Short Trade."