Michael Shulman

Making a Short Trade

by Michael Shulman   09/08/08

There are some trading issues far more important when shorting a stock, or playing the downside through buying puts, than holding a simple long position in a stock.

* Liquidity: You really should not short, in any form, a stock that is not highly liquid, which means many millions of shares outstanding and hundreds, if not thousands, of put option contracts trading each day at each available strike price.

Without liquidity, you can be right and wrong at the same time -- right about the company but stuck in such a way that you cannot quickly liquidate your short position and get the profits you deserve. Liquidity should be a prime consideration when establishing short-side positions.

* Availability: Some stocks are hard to short because their shares are not easily available to borrow, for a variety of reasons. And if you are finding it hard to locate the shares to conduct the transaction, it means there is either a large short position in the stock already or the stock is not held by a large number of individual shareholders, which means it is less liquid than trading statistics may indicate.

* Outstanding Short Position: This is the number of shares of a company held short, measured in absolute numbers, or as a percentage of the float of the stock. If this position is large, more than 10% to 20% of a company's shares, the word is out -- bad news is already incorporated in the stock price. For the most part, I avoid stocks with large short positions, and so should you.

* Cash for Margin Calls: If a stock moves the wrong way (up) and you have shorted the stock outright instead of having bought put options, you are going to need cash to meet margin calls -- perhaps daily. This is a nasty situation that ties up your capital, which is why I typically look toward puts or LEAP puts for shorting.

If you enter a short position, be aware that things can easily move the wrong way and you will need cash to fund the margin call or else you will have to go into the open market and buy the stock to cover your short position.