Faceoff: Short selling

Mark Armstrong, the vice president, investment advisor at Richardson GMP, Saskatoon and Richard Knowles, financial planner, R. Knowles & Associates, Vancouver, join the Advisor Group to debate the practice of shorting stock.

Mike Armstrong: Arbitragers, speculators and some individual investors engage in a practice known as shorting stock. They make money when the price of the stock they’re shorting goes down. To short stock, you must open a margin account with your brokerage firm. You’ll be charged interest on the borrowed funds [and be] subject to several rules and regulations that govern shorting stock. Because short selling is done in a margin account, the trader uses leverage to increase profits (or accelerate losses if the trade goes bad). Some investors practise shorting stock as a hedge to protect their portfolio. In most cases, this isn’t required or recommended for individual or institutional investors.

Naked short selling to purposely drive down the price of a stock is considered market manipulation and is against the law. Short selling — especially naked short selling — isn’t recommended for inexperienced investors. The practice is just short of gambling, and that’s not the way you want to handle your nest egg.

Richard Knowles: Short selling drives down markets and profits from catastrophic losses. It helps drive a stock or stock market down further, feeding a loss with the intent to exacerbate a negative situation. It’s perceived and often used to be devious and dangerous to others. The Canadian federal government [has stopped] short selling [for] financial and banking stocks, as this sector [is perceived to be] an essential economic service. Now, this makes you think, if it’s officially acknowledged that borrowing to short hurts one part of the economy, then [maybe] it’s all threatened by it.

What clients should be using this strategy?

Armstrong: This type of strategy is typically only really appropriate for very sophisticated retail investors or institutional traders, who may use it as a form of hedging. The typical retail client won’t have the tools available to them to reduce the risks to a manageable level. Most retail brokers also don’t have the time or expertise to make this a consistently winning strategy for their clients.

Knowles: Shorting (and stock trading in general) works best with more sophisticated clients with good understanding of macro- and micro-economics; also, ones who are technologically comfortable with computers and mobile devices. When it comes to market timing of a stock (to sell high and buy it back at a lower price), it’s advantageous for all clients, but the truth is many people don’t have the skills to understand the technical and fundamental dynamics of a company or the economy well enough to get in and out in a timely way. To buy and sell a stock takes a cost, so the client needs to be sure the drop is adequate to cover that cost. A client always has to be prepared to lose money. The market goes both ways.

When is the best time to short stocks?

Armstrong: I’m not sure if there ever is a best time to short stocks because it’s not so much a market-related event as an individual company/stock/sector event that’ll trigger gains or losses on a short. If market trends or an individual company’s trading pattern is clear, then that may be an appropriate time to consider a short. However, this can quickly change and that’s why this is a strategy not for the faint of heart. Money, time and patience are required if an individual investor wants to make this a part of his or her regular portfolio strategy toolkit.

Knowles: There are some more obvious trends that I’ve noticed. There’s a noticeable correction, sometimes quite dramatically negative, in Canadian and U.S. stocks in the October-to-November corridor. This economic condition arises [in] a majority of years for reasons I need not get into here, but it repeats itself for sound reasons about nine out of ten years. The decline varies from a very little to a lot but the most severe drops historically we’ve witnessed have occurred in this time corridor in North America.

But while a broad market may correct during this period, many individual stocks might not because of some recent discovery, like a gold or oil play, or a new advancement in technology. [This] can happen at any time, [and] make that stock grow rather than drop, so short selling always carries that inherent risk. It’s important to do your homework.

Is now a good time to implement the strategy?

Armstrong: The current market environment, with its extreme volatility and with no clearly discernable catalysts, makes this a risky and very aggressive strategy with questionable returns. Any time markets trade mostly on emotional sentiment, it’s difficult to reduce the risks and increase the odds of success using this strategy. An “Aha, I called it right!” trade can quickly become an “Oh my god, what did I do?” trade, given current markets’ intra-day volatility.

Knowles: This is not a good year [for shorting]. Still, I and many other technical analysts expect a negative correction based on more recent data that the economy can’t support the ongoing recovery. Many broad market pundits and fund managers support this and expect less-than-stellar data. [And] the [more] negative sentiments of analysts and managers and brokers working in the stock market system, the more likely it’ll occur. We end up the purveyors of our own fates, as it’s a majority rules stock market.

How do you pick the right stock/sector to short?

Armstrong: To be successful, it’s important to identify companies or sectors that have clearly run up too fast, and/or the current price is unsupported by fundamentals, or bad news [is] about to be released or has been released and you’ve been given an uptick or zero tick.

Knowles: Do the homework and don’t cheat. Good research, some homework, knowledge and fundamental and accrued experience are necessary. It isn’t for the faint of heart or inexperienced. And it can change daily. It’s about now looking for bad news rather than positive [news]. It’s different and is a philosophical change from many people’s way of thinking.

What are the potential risks?

Armstrong: Short sellers, naked or otherwise, can get caught at their own game in what is known as a short squeeze. This happens when the shares of a shorted stock rise instead of falling. Short sellers are [then] forced to buy shares on the open market to cover their position, but if enough short sellers try to buy the same stock, it’ll only push up the price further, increasing the losses.

What if the price of XYZ stock [rises]? The person shorting stock would have had to buy back the shares at the new higher price and absorb the loss personally. Unlike regular investing, where losses are limited to the amount of capital invested, [in short selling, there’s no limit] to the amount you [could] lose.

Knowles: Short selling means borrowing stock beyond [what’s owned]. No matter what occurs, after selling shares you’ve borrowed in a short sell, they have to be bought back later. If you buy back at a higher price, you lose — an amount that could put a client at severe financial risk.

What are the possible rewards?

Armstrong: The maximum reward of shorting is 100%; in other words, receiving the full sale amount of proceeds if the stock you’ve shorted goes to $0 or ceases to trade permanently. Typically, shorting transactions won’t receive a reward this high, as it’s very difficult to call companies or stock that will trade to $0.

Knowles: In the case of borrowing stock in a true short sell, the reward is, by far, much more money. It’s possible for people to make themselves enormously wealthy with borrowing a stock, as the rates of return without any money down are astronomical. Just remember, losses are statistically unavoidable. One short-sell broker and trader with clients put it this way, “Once you’ve made some profits, never put it all into play. Hold back enough in cash to cover a loss of the next short sell.”

Reader Alert: Agree? Disagree? Leave a comment below and vote in our poll here.