Short Selling Made Simple – Investing in Reverse

An Investment U White Paper Report

by Investment U Research

Almost any investment technique will work well in a bull market – but they collapse when the markets turn treacherous… like they did not that long ago.

Bear markets have been outlandishly profitable for investors who used the short selling technique. This report will provide the education needed to learn how to safely make profits.

Please note: This does NOT involve the use of options, futures or any other kind of risky derivative!

The short selling strategy is one part “contrarian investing,” one part “short-term profiteering,” and one part “capitalizing on the biggest financial conspiracy since the breakup of Standard Oil nearly a century ago.”

It is a radically different approach to investing… one that can earn big short-term profits using a simple technique.

Why Wall Street Won’t Tell You To Sell

Wall Street almost never tells clients to sell specific stocks. At best, they write a mildly positive-to-ambivalent research report that will leave the average investor in a state of inertia (which means the stock remains unsold). In rare cases, when the outlook for the company is particularly bad they might say they are “neutral” on the stock. Or they use the term “reduce.”

Even if the company’s outlook is atrocious, Wall Street firms don’t want to step out front and say, “Sell this stock.” Because if they do, that’s one company that definitely won’t use their investment banking services. And who needs the advice and services of an investment bank more than a struggling, downtrodden company?

Bottom Line: When you need to know which stocks are troubled and headed down, Wall Street is mute. Like we said before, it’s a silent conspiracy. And the people they’re conspiring against are you and every other investor out there.

Here’s what they don’t want you to know…

• Stocks go down faster than they go up.

• A lot faster.

I shouldn’t have to remind you how quickly stocks plummeted in the financial crisis of 2008-09.

History shows that stocks throughout the 20th century rose just over 11% a year. Yet individual stocks routinely tumble by that much or more in a single day.Why wait years for an 11% profit if you can earn these kinds of returns in a matter of days when a stock sells off?

And you can. Imagine earning an immediate 54%, for instance, when a stock gets sacked at the opening bell. It would take five years of average stock market returns to get that kind of performance. Yet you can profit from plummeting stocks… simply… easily… safely… and effectively.

Unfortunately, too many investors are mystified when it comes to the investing technique called “short selling.” But there is nothing complicated or difficult about it. Short selling is simply acting to capitalize on falling share prices.

And there are plenty of opportunities for short sellers… even in the hardiest bull markets.

Several Good Reasons to Start Selling Short

Short selling is a tool that can be valuable in a number of ways.

For instance, you may want to speculate that a stock is likely to decline. There could be any number of reasons. You may feel that its sales have topped out, that earnings will fall short of expectations, that the company has too much debt or too many successful competitors, that its industry is in a slump, or simply that the shares are overpriced. Short selling allows you to take advantage of these situations without resorting to using options or other derivatives.

While options can give you leverage that a short sale cannot, they have one very serious drawback: their time premium. That means when you buy a put option, unless the stock falls fairly substantially and within the relatively short time period defined by the premium, you may miss out on the profit if the stock falls after the expiration of your option.

Benefits:

• Short selling positions don’t have time premiums. You can hold a short position indefinitely. They do not expire.

• Another reason to sell short is to hedge your existing stock portfolio. Perhaps you have a substantial percentage of your liquid net worth tied up in stocks. If the broad market declines, so will the majority of your stocks.

By selling short a few stocks, or even the market index, you allow the potential profits in your short positions to offset the decline in the share prices of the stocks you own. For example, if you have technology stocks you can offset the risk here by selling short the Nasdaq 100, symbol QQQQ.

Or you can offset the risk in your blue chip stocks by selling short either the Dow, via the publicly traded index “DIA,” or the S&P 500, via that publicly traded index “SPY.” Both are highly liquid and easily available for brokerage firms to lend. But please consider this we never recommend shorting the Dow or the S&P 500 indexes, unless you’re doing it as a hedge. These indexes consist of the best companies in America. We think you should be shorting just the opposite: the worst or at least the most-troubled companies you can find.

In fact, often times investors will follow the strategy of buying the strongest stocks in an industry while simultaneously shorting the weakest ones. That may mean buying Wal-Mart and shorting Kmart. Or buying Exxon and shorting BP.

And of course, if you’re feeling bearish, you can short any of the foreign market indexes. If you want to short Japan, the symbol is EWJ. Hong Kong is EWH. Switzerland is EWZ. Mexico is EWW. And so on. There is a whole list of market indexes you can buy or short at www.ishares.com.

Selling Short Made Simple – Investing in Reverse

Selling short is simply the reverse of a normal stock transaction. Ordinarily, if you’re buying a stock to take advantage of its expected rise, you might buy it at $15 and then close out your position by selling it at $30, making $15 a share.

Short selling is just the opposite. To take advantage of a company’s potential share price decline, you might sell it short at $30 a share, and then close out your position by buying it back at $15 a share. You would make the same $15 a share on this short sale transaction that you would earn on the previous transaction described above.

But how can you sell something you don’t own?

Well, that’s why it’s called selling short. It means selling something you don’t own. But to transact the sell, you must offer the shares up in the market. And you do that by borrowing them from your broker. In theory, he lends you the shares, so you can short sell them. Then when you buy them back, these shares are returned to your broker, completing the transaction.

Two Important Considerations When Short Selling: Legal and Retirement Account Issues

First, by law, all short sales must take place in a margin account. So your broker will have you open a margin account – if you don’t already have one – before you can execute a short selling transaction.

Second, because these trades are executed via a margin account, it is not possible to sell short in an IRA, Keogh or some other qualified retirement plan. You must sell short in a non-retirement account.

So the first thing you would do is check with your broker to see if he has shares in his inventory to lend. A broker’s inventory includes virtually all shares held in his clients’ margin accounts, so most big, liquid stocks can be sold short fairly easily.

However, not every stock is marginable (or eligible to be traded through a margin account). For instance, if a stock is not marginable, it cannot – by definition – be sold short. That precludes most penny stocks and foreign shares. And most brokerage firms have their own restrictions on margin trading – including not lending shares to be shorted if the price is under, say, $5 or $3. They often feel that these shares are too risky to be sold short.

What to Tell Your Broker to Short Sell Correctly

After you have set up a margin account with your broker and have checked to be sure that you can borrow the shares you would like to sell short, you then read your broker the order (or place it online).

The exact terminology is this: “I would like to sell short 1,000 shares of XYZ at the market.”

You can, of course, place a “limit order” if you like, and thereby stipulate the price you’ll get when your order is filled. If you do set a limit price, however, you will not get the order filled until that price is met.

Also, most firms will not accept a “good-’til-cancelled” order on a short sale. The order generally will be canceled if unfilled at the end of the day. Then you must enter the order again the following business day.

When you go to take profits or complete the trade, your terminology would be this: “I would like to buy to cover 1,000 shares of XYZ at the market.”

Again, you can use a limit order to stipulate your price if you prefer, but it’s subject to the same restrictions as when you first borrowed the shares to sell.

So transacting a short sale is fairly simple. Now let’s discuss the returns possible with short selling.

The Potential Upside from Short Selling: Faster Profits and More Opportunities

Because stocks always go down faster than they go up, your profits could come much sooner. However, your maximum upside in any short selling trade is 100%. Or 200% if you’re fully margined. The reason for this, of course, is that stocks cannot fall more than 100%. Hence, that is your maximum profit unless you’re using leverage (i.e., margin).

Another upside is that the whole market may be trending lower at times. When that happens, the trend is your friend. Studies show that three-quarters of all stocks follow the broad market trend. That puts the percentages on your side during a bear market.

Still another advantage of short selling is that you don’t have to put up any money to take your short positions. You can simply use your existing equity in your brokerage account as collateral. Of course, your broker will charge you margin interest until you close out your position.

And Now the Downside – Why Your Neighbor Doesn’t Sell Short

There are risks to selling short, of course. The first is that, theoretically at least, there is no limit to how high a stock can go. We say theoretical risk because there’s never been a stock that rose an infinite amount. Not even close. Yet nay-sayers will interpret that technicality as meaning that there is no limit to how much money you can lose.

Fortuantely, we know a good rule of thumb to generally avoid such losses.

We recommend adhering to the 25% rule. Any time a short position goes against you by that amount, get out by telling your broker to “buy to cover.” There will always be other short sale opportunities. Never try to rationalize that the stock will eventually come back down. Being a successful trader means having an exit discipline and sticking to it. You can always short a stock again if it begins moving down.

Another risk to short selling is known as a “short squeeze.” A short squeeze occurs when the brokerage firm must return your borrowed shares to the owner, perhaps to settle trades that have taken place. This is a rare occurrence but it can happen, especially if a stock is somewhat thinly traded. In such an event, you have no recourse: you must buy the stock back regardless of whether you are in or out of the money. Again, this is a fairly rare occurrence but you should be aware of the possibility all the same.

It is also important to know that short sellers are responsible for any dividends paid. The reason is this: If a stock pays a $1 dividend, it will open $1 lower on the ex-date (the date the dividend is paid), all things being equal. That is not simply a windfall to short sellers. Your account will be debited $1 per share. For this reason, it is often wise to avoid high-dividend-paying stocks unless the fundamentals are truly atrocious or the dividend itself is in jeopardy.

The Best Selling Short Candidates: Fundamentally Challenged Companies

The approach most short selling advocates take is pure guesswork – they have a hunch that the overall market is going down and so they short Dow stocks or they believe a certain sector is overvalued, and they advocate shorting the leaders in that sector or they short companies that are simply too expensive.

Our approach is vastly different. We target troubled companies (that is, companies that are already stumbling because they’re wrought with fundamental problems). The more intractable the problems, the better we like the odds. Here are just a few of the criteria we use to exploit these opportunities:

• Corporate malfeasance, like the lawlessness at Satyam Computer Services (NYSE: SAY) in India in 2008.

• Industry overcapacity, like any number of stocks in the crashing computer bubble a decade ago.

• Antitrust problems, like the kind that cut Microsoft (Nasdaq: MSFT) shares from $120 to under $50 in the 1990s.

• A heavy debt load, like the kind that drove down Ford (NYSE: F), General Motors and Chrysler at the onslaught of the credit crisis.

• Lost market share, like the kind Wal-Mart (NYSE: WMT) wrestled away from Kmart little by little, causing Kmart to tumble from over $40 a share into bankruptcy, and less than $1 per share.

• Industry-wide image problems, like the type that hit oil companies after the recent BP rig explosion off of the Louisiana Coast.

• Perceptions of potential fraud or abuse, as in the case of any number of big banks in 2008 into 2009, as they spent large amounts of money on company getaways and other expenditures that the public took issue with.

• Weak pricing power, such as in the natural gas industry, where an over supply has caused the commodity’s prices to tank.

• Mergers gone bad, like the tie up between Hewlett Packard and Compaq (HPQ) in 2001. Within weeks, shares of the combined companies lost more than a third of their value.

And these are just the high-profile bombs. The list could go on and on. Anyone who has run a business knows that there are endless ways for things to get off track.

But the bottom line is that things happen, whether they be mistakes or more duplicitous errors. And when they do, smart investors know how to take advantage.

Good luck and good short selling.

– Investment U Research