Shorting is a common technique on Wall Street as investors try to profit from both the rise and falls of a particular stock, but one thing I never really understood is why short in the first place.
Definition of shorting according to Investopedia.com
The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Yes, some individuals are successful
Bill Ackman comes to mind as a successful short. Im pretty sure there are other individuals who have successfully shorted stocks for a living and will continue to do so.
Logic
I might not be the smartest men alive, but logic is the main reason I avoid shorting. Here it goes:
If I short a stock, my biggest gain will be 100% and my biggest loss could be limitless (assuming I do not get a margin call). On the other hand, if I buy a stock, my gain could be infinity, while my downside is limited to losing my intial investment or 100%. Now that’s what I call controlling my risk/reward.
An example:
On January 2007, David Dreman wrote an article for Forbes properly titled “Short The Exchanges“, in which David Dreman considered the stock exchanges (CME,ICE,NYX). At the time of writing, Chicago Mercantile Exchange Holdings (CME) traded at $530. The stock continued its unprecedented run up to $714. The stock is well off its highs, but an individual would have had to stomach a 35% increase in CME’s stock price.
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{ 7 comments… read them below or add one }
Alex,
In order to be a profitable short seller one has to use technical charts, stop loss orders and have a traders mentality.
In addition to that you have to check the sentiment on the stock. If everyone is bullish then you can short more safely than when everyone is bearish yet the stock keeps on climbing..
Shorting is definitely tough as you point out. Anyone who started shorting the financials a bit too late (like 2 weeks ago) got slaughtered, with some of hte distressed ones like the monoline insuers up 300% to 500% in one month. It’s even more difficult for value investors who generally don’t rely on technicals, use stop losses, and so forth.
Even if you are right with your call, you may not survive long enough. Marc Faber said one of his worst mistakes was shorting the NASDAQ back in 1999. His call was right but he had to sell out with huge loss because bubbles can keep going up long than you can remain solvent.
I’m quite skeptical of value investors who sell short. Many such as Walter Schloss (tech), Prem Watsa (credit), and William Ackman (credit) have been successful over the years. But I always feel like they are crossing the line and going more towards speculation with their bets. I also find it bizarre whenever someone like David Dreman raises the possibility of short selling.
DGI:
“fitable short seller one has to use technical charts, stop loss orders and have a traders mentality.”
Most value investors including myself have no idea how to use or read a technical chart and are very unfamiliar with most terms. Also, most value investors are trying to get away from a traders mentality.
Siv,
Spot on, I could not agree with you more
I think this misses the real point about the valued-added nature of short positions in a portfolio; they can allow you to decouple returns from a broad stock index, and while I’m not a real believer in MPT, this kind of simple hedging can have a lot of value for funds targeting low-vol returns.
And FYI… there are pure-fundamental short sellers (i.e. Jim Chanos at Kynikos)…
Alex,
I am sorry for the misunderstanding. I meant that as a value investor its tough to be short stocks because usually its more difficult to short shares because people can get irrational.
I read on Geoff Gannons blog that Ben Graham tried shorting stocks which appeared overvalued, but he wasn’t as successful as buying undervalued stocks.
In my fundamental stock screening I don’t recommend shorting, just staying away from a stock.
As for chart reading, I swear I read somewhere a quote from Buffett saying that he did use charts some time in the 1950’s.
As far as I know Buffett only used charts when he was a teen. Buffett said he started out reading charts–he actually said he tried many methods–but gave that up after realizing it didn’t work. Basically when he read the Intelligent Investor, that was the beginning of the end of everything else.
If he did use charts in the 50’s, which would be when was an adult I think, that would be news to me.
Having said all that, I think Buffett and others did short sell stocks. At a minimum, they took long-short arbitrage positions so they would have shorted for that.
Short selling is fine; it’s just that Keyne’s words are hard to overcome: market can stay irrational longer than you can stay solvent.
Shorting is for experts who know what they are doing. Afterall, the majority of people who short stocks, are seasoned professionals. The general public is too afraid to short. Maybe some day, you’ll learn how to short stocks.
- Vooch