Wednesday, July 16, 2008

Short Selling America

In case you hadn't noticed, there is a severe economic downturn in this country concurrent with the vast majority of stock prices continually decreasing over the past year or more. If you are unfortunate enough to own shares of banks, then the decrease in share price has been precipitous, or more like falling off the edge of the cliff. With the economy and the prices of stocks continuing to head downhill, America holds its collective breath wondering where and when it will end. The vast majority of investors have suffered declines in their portfolios, both stocks and mutual funds, and the choice seems to be between waiting the storm out or "going to the sidelines with cash."

There is another option in the investment arsenal that is called "short selling." When you short sell a stock, your broker lends 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 short by buying back the same number of shares (called covering) and returning them to your broker. Short selling is a risky investment technique, but at times like this it can lead to substantial profits. Do not do this without doing considerable research and talking it over with your brokerage firm!

Some investors have been making a steady income by short selling General Motors, Lehman Brothers, Toll Brothers, and the number of other stocks whose prices have consistently declined for the past year. Short selling has gotten a bad name because it has been blamed for decreasing stock prices. There is nothing wrong with short selling and it by no means explains the decreases in stock prices. In a way, it seems somehow un-American to make money by selling somebody else's stock. Well, there is nothing patriotic about watching your investment portfolio shrink from month to month to month not knowing when it will turn around. I want to make it clear that this post should not be construed as a recommendation to get involved in short selling. Rather, the purpose of this post is to point out that for people who know what they are doing, short selling the majority of stocks in America has been a profitable, if vaguely un-American, investment option during the past year.


Anonymous said...

It is the "covering" part that concerns me. What if the stock suddenly starts going up, up and away? Do you then buy it for more than you sold it in order to cover?

Neil Benson said...

If the stock goes up in price and you decide to cover then you will lose money. You can wait for the price to come down. Then you run the risk of the price going higher and the cost of covering going up. That's what makes short selling so risky