In short selling, it’s sell high, buy low and maybe anger some

On the Money
From the February 1, 2008 print edition

There’s an old joke that says, “Want a hot tip? Buy low, sell high.” Of course, that “tip” will only be “hot” if the price is also rising.

Recent indicators all around us are signaling a very cool market. Some speculate a recession is near. That usually means falling stock prices. Therefore, the old hot tip of “buy low, sell high” might not come to pass anytime soon.

So, how about a new tip? Sell high, buy low. In the dice game of craps, that’s called betting against the dice, or “don’t pass.” In the more scholarly circles of finance, it’s known as the “short sale.”

In other words, while everyone else is bemoaning the decline in the price of the stocks they bought low with the hope of selling high, the short seller happily watches the prices fall.

But how do you sell something you don’t already own?

Here’s an examination of short selling.

A short sale is the sale of a stock you don’t own — yet. Investors who sell short believe the price will fall. If the price drops, they can buy the stock at the lower price and make a profit. On the other hand, if the price of the stock rises and you buy it back later at the higher price, you will incur a loss.

When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of one of its clients or another brokerage firm.

The practice of “naked short selling” is selling the shares without first arranging to borrow them.

As a basic example, Quirky Telecom Inc. is trading at $80 a share. The investor borrows shares of Quirky Telecom Inc. stock at $80 a share and immediately sells them.

Later, Quirky Telecom’s stock price declines to $60 a share, and the investor buys shares back on the open market, replacing the borrowed shares. The investor can’t realize the profit until they buy back shares of Quirky Telecom on the open market. The profit is $20 a share, less commissions and fees, of course. Voila — sell high, buy low.

However, if the price rises, the investor loses money, possibly an unlimited amount, since a stock price can theoretically rise indefinitely.

Just as people who bet against the dice at the craps tables aren’t very popular, short sellers often are regarded with disdain and distrust. In

fact, short selling wasn’t always legal.

In the 18th century, England banned it entirely, since the practice was thought to have escalated the dramatic downturn in the Dutch tulip market in the 17th century.

Rule 10a-1 of the Securities and Exchange Act of 1934 banned short selling during a downtick. A downtick is when a transaction occurs at a price below that of the previous transaction. That rule was ended in 2007. The Investment Company Act of 1940 banned mutual funds from short selling. That law was lifted in 1997.

Certain market conditions generate mass short-selling activity, particularly during “bubbles,” times of irrationally high prices. During such periods, short sellers hope for a market correction. Significant positive news announcements often cause the market to react illogically, simply because of media attention.

Short sellers use the opportunity to sell into the buying frenzy and wait for the exaggerated reaction to subside before covering their position. Negative news, such as litigation against a company, also will entice professional traders to sell the stock short.

Short sellers frequently are regarded with disdain because, in the views of many people, they’re profiting from the misfortune of others. Some businesses campaign against sellers who are shorting them, sometimes bringing litigation.

The practice of naked short selling is getting more regulatory scrutiny.

Conversely, advocates of short selling say that the practice is an essential part of the price-discovery process. Short seller’s scrutiny of companies’ finances has led to fraud discoveries, which were glossed over or ignored by investors who had held the companies’ stock long.

Although the vast majority of short sales are legal, abusive short sale practices are illegal. For example, it’s prohibited for any person to engage in a series of transactions in order to create actual or apparent trading activity, or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others. The SEC prohibits short sales designed merely to manipulate the price of a stock.

To keep short selling, especially naked short selling, honest and non-abusive, the SEC adopted Regulation SHO in 2005. More information about the regulation and short selling in general may be found at www.sec.gov/spotlight/keyregshoissues.htm.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.