Michael Shulman

What to Know When Making a Short Trade
by Michael Shulman   05/01/08

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.

Timing: Timing in life is almost everything (where would I be if I had not been invited to the party where I met my wife?), and the same is true for managing short positions. You should set time horizons for how long it will take a position to pan out and, if it does not, it is time to take some losses and move on.

Unlike long positions, where investors can wait out a slowdown in a stock's appreciation or a dip in share value, short positions are expensive to maintain and puts are contracts that can expire worthless -- the clock is always ticking.

Most good short positions take no more than three months to move in your favor; longer-term shorts, which should always be managed through LEAPS, can run much longer but are less typical than the six- to 12-week position.

How to Cover: Believe it or not, you can end up owning a stock and shorting it if you are not careful with your instructions to your broker. When you call or go online to cover a short position, you must specify that this purchase is to cover the open short position. If you do not, you could end up buying the shares and have them sit in your account and also have an open short position at the same time.

Because short-sellers might find themselves exiting their positions in a hurry, it's important to take the time to ensure that you issue clear instructions to your broker so that you get out when you want to!

Let's wrap up: The real issue, of course, is picking the right company that's going south. But you need to mindful of all of the things I discussed today, and that requires some planning, some preparation, some discipline and some clarity of thought.

You used that on the long side; now, use it make short-side profits, as well.

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