The Basics of Short Selling

It’s only a matter of time before the Federal Reserve runs out of tricks to make it seem like the U.S. economy is humming along nicely. By the time most investors wake up to the danger, it will be too late… and billions, if not trillions, of stock market wealth will vanish.

But you don’t have to be a victim. In fact, you can also try to turn the market’s woes into positives — making money as stocks fall.

It’s a strategy that Joseph Kennedy, head of the Kennedy clan, used to add $1 million to his family fortune when the stock market collapsed in 1929. At the same time, famed investor Jesse Livermore used it to boost his net worth to $100 million.

When the market cracks up again, you’ll have a chance to put this technique to similar use yourself. We have a section of Stockman’s Contrarian Portfolio that employs this strategy.

It’s called “short selling.” This module will explain everything you need to get started with it.

Doing What Needs to Be Done

You may have heard of short selling before… and you may think it has very negative connotations. On the surface, making money from falling stocks might sound a little unethical.

So before we begin, let me make this perfectly clear: Shorting a stock is NOT taking money out of someone else’s pocket. You are NOT doing anything to make the stock fall in value. And you are NOT profiting from someone else’s misfortune.

Instead, short selling is about taking a stand against unbridled greed. Think about it —investors only sell a stock short if they think the stock’s price will go down. And the only reason the stock price will go down is if the stock price doesn’t reflect the company’s value. If a stock is overvalued, it’s because investors believe the company’s hype.

As a short seller, you’re looking past the hype — glaring at the company itself. And if you see there’s not as much value there as investors believe there is, you almost have an obligation to short the stock. For one thing, shorting the stock may convince people to take a closer look…and see what others haven’t.

Short sellers publicized accounting frauds at Enron, WorldCom and Tyco long before anyone else noticed. They prepared for the bursting housing and mortgage bubbles while everyone else was busy refinancing and flipping property. So short sellers are really the market’s early warning systems. And if investors refuse to pay attention, you can at least limit the stock’s damage as it falls.

Remember, stocks are not a zero-sum game. There isn’t a winner for every loser. If someone buys a stock at $20 and sells for $30, he’s made $10. Nobody has lost any money, though, and his profit gets recycled into the economy. However, if he buys the stock at $20 and it goes to $10, the $10 he lost is gone forever. At least, it is unless someone has shorted the stock.

A short seller has a chance to recover some of that money. So instead of disappearing, it can be re-injected into other investments. Now, all of this is not to say that you deserve some sort of medal for shorting stocks. Let’s face it — you’re in this for the profits. I just think it’s important for you to understand that you’re not doing anything wrong by betting against a company. The trick, of course, is to figure out which companies are overvalued and ripe for a fall.

That’s why I’ve developed five criteria to zoom in on them.

Five Traits of an Overvalued Stock

I’ve found that five things predict whether a stock is overvalued or not:

  1. An expensive stock price
  2. A contracting customer base
  3. A history of making value-destroying acquisitions
  4. Aggressive accounting
  5. A very generous stock option program.

Let’s take a little more in-depth look at these.

An expensive stock price

An accurate definition of an “expensive stock” is a stock that has increased far higher than the fundamentals justify. Some bull markets are justified. Other bull markets are not justified.

Consider the dot-com bubble. The huge runs in these stocks were not accompanied by growth in earnings and cash flow. Instead, momentum traders and psychological mania — hype, hope, and fear of missing out on the crowd’s profits — held them aloft.

You did not want to be shorting these stocks as long as the psychological mania and momentum held strong. Expensive stocks can always get more expensive. But make no mistake, the tide will eventually turn…and that’s when you strike.

During the dot-com bubble, that turnaround came in spring 2000. The psychology turned, and momentum traders started bailing out. Experienced short sellers knew that these stocks had an awful lot of room to fall — in the range of 90–100% declines. You could have made a fortune shorting a basket of the most egregiously overhyped dot-com stocks. The classic examples:, eToys, Ask Jeeves,, InfoSpace, Razorfish.

A contracting customer base

Obviously, companies need customers to survive. Companies that are suffering a contraction in their customer base will experience declining sales, earnings, and even balance sheet erosion. But the Street may often fail to recognize it, choosing to value a particular stock by assuming past sales and earnings trends will continue indefinitely into the future.

An example of this would be USG Corp., a leading manufacturer of Sheetrock for use in new home construction. In the mid-2000s, it was a low-cost producer and had a good management team. It’s also owned partly by Warren Buffett’s Berkshire Hathaway, making it a long-time favorite of value investors. But as the housing market started collapsing in 2007–08, building supply companies suffered a huge contraction in their customer base. As new home construction plummeted, earnings estimates for USG did as well. The stock went from as high as $120 to under $10 in less than three years.

Company financial reports often discuss the customer base… but don’t expect them to highlight it if the news is bad.

A history of value-destroying acquisitions

Some executives are “serial acquirers.” They care more about building a personal empire than building shareholder value. They have the bad habit of constantly diluting shareholders with secondary stock issuances.

A classic example is Tyco Intl. in the late 1990s, when Dennis Kozlowski ran it. Kozlowski was a sweet-talker who overpaid for a hodgepodge of industrial companies, yet he successfully marketed this conglomerate as “the next GE.” That is, until early 2002. That’s when the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up. All those acquisitions destroyed value because the negative of constant stock dilution more than offset any positive gained from the acquired companies.

Of course, expansion isn’t always a bad thing. Some of the warning signs to look for are acquisitions of companies unrelated to the business…paying a stiff premium for the acquisition…or acquiring a company that’s on a downward skid.

Aggressive accounting

Companies work hard to make their earnings look as good as possible. But sometimes their number-boosting schemes go too far. Take Tyco. Its rollup strategy included an accounting tactic called “bootstrapping earnings.”

Here’s how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy “old economy” industries. After the books closed of these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth.

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s book value, the difference usually ends up as “goodwill,” an intangible asset on the acquirer’s balance sheet. Unlike physical assets such as plants, goodwill and other intangibles are hard to value and can, in fact, be worthless.

Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001. This was a big red flag. How could investors possibly estimate the intrinsic value of the underlying businesses? Tyco is not a software company in which nearly all assets are contained in the minds of programmers and in lines of code. So the explosion of intangible assets was not justified.

“Bootstrapping” (and other merger-related accounting techniques) is just one of the many accounting red flags to look for. Others include capitalizing expenses, channel stuffing, related party transactions, and using off-balance sheet accounting to hide the true financial picture.

Another thing to look for is a very generous stock option program. Companies often offer stock options as an employment incentive — promising shares of the company in lieu of money.

There’s nothing wrong with that… in fact, giving staff a stake in the company is a perfect way to make sure workers act in the company’s best interests. But sometimes a company gets a little too generous with its options. It hands them out like candy, or backdates them to make them more attractive. Either way, it dilutes shareholder value.

Take the case of Broadcom. Back in 2000, the company issued many options when the stock was above a split-adjusted $100 per share. But when the market hit bottom in 2002–2003 and Broadcom’s shares fell sharply, those options were worthless. So to make its employees happy, Broadcom repriced those options.

Forty-nine million options with strike prices in the range of $32 were tendered in exchange for options with strike prices in the range of $22. This ultimately amounted to $49 million less for future company operations or capital expenditures. The result was a dilution of shareholder value and, ultimately, a lower stock price.

Figuring out if a company is playing games with its options can be tricky. But once you see the warning signs, you know you’ve found a company ripe for a fall.

Of course, a company doesn’t need to have all five of these traits to be a potential loser. But it will have several of them. And once you’ve identified a target, it’s simply a matter of choosing the best way to play it.

You could buy put options — options contracts that go up in value as a stock’s price falls. Or could you try to profit more directly from a stock’s fall by selling it short.

Let me tell you what selling short means in the simplest terms.

Shorting a Stock

Let’s say you think that Stock A is going down in price, and you want to take advantage of it by selling the stock short.  To do that, you borrow shares of Stock A from your broker. You immediately sell the stock, collecting money for doing so. Later on, you buy back the same number of shares and give them back to the broker.

The goal is to sell the stock when its price is high, and buy it back when it’s low. The broker gets back the shares he lent out, and you pocket the difference between the two prices as your profit.

Now, the trick is finding the stock to borrow. Say you want to short 100 shares of Bank XBA. You’ve first got to see whether your broker has 100 shares to lend.  If there are none, then you’re out of luck.  But if there are shares to borrow, you can short Bank of America. So you enter an order to sell 100 shares of XBA. When the order is filled you now owe your broker 100 shares of XBA. To cover your position, you’ll eventually need to buy 100 shares of XBA — ideally at a lower price — and close out the position.

Risk Factor: The 1 Thing You Must Know

Note the big difference between going long, buying puts and selling short.

In going long, unless you borrow money to buy stock, you can’t lose more than 100% of your money, and your profits are unlimited. When you buy puts, you risk a known amount, and can only lose that amount, but your profit is unlimited.

However, when you sell short, your profit maxes out at a 100% gain. For that to happen, the stock has to go to $0, essentially meaning bankruptcy, so there is no need to replace the shares you borrowed from your broker,

At the same time, your downside is unlimited. That is, there’s no limit to how high a stock’s price can go. The higher it goes, the more you’ll have to pay to replace your brokers’ stock. In theory, this could go on forever — but you can bet your broker will close you out long before that happens.

In other words, this isn’t a move for amateurs. But if you’re up for the challenge, it can be very rewarding.

Before you start, however, you will need to take certain steps.

Here’s How Your Account Will Work

First, you’ll have to open a margin account with your broker. That doesn’t mean you’re using borrowed money. It just means that you’ll be making an initial deposit, typically $10,000. Think of it as a security deposit. It’s your collateral, better ensuring that the borrowed shares will be returned to the lender down the line.

Each time you sell short a stock, you have to have the initial margin in your account. Trading rules demand 100% of the short sale profits, plus the value of 50% of the short sale proceeds in addition — as an extra cushion.

So say there’s a $15 stock, and you sell short 1,000 shares. So you get an immediate deposit of $15,000, and that goes into the account. Plus, you need to deposit an additional $7,500 (or 50% of $15,000), bringing your total initial margin to $22,500.  You can’t use the proceeds of your sale towards any other securities or take it out of your account.

Placing Your Trade

Most online brokers will offer you a check box that says “short sale” or “buy to cover.” Know that your transaction should be in a round lot, the minimum is a block of 100 shares.

They’ll have to check to see if the shares are available. Your broker has three places it will borrow from: its own inventory, another brokerage, or the margin account of one of its clients.

What Happens When the Trade Goes Against Us

If the trade moves against you, and the price of the stock goes up, you may be required to put up additional margin. This is known as a margin call. It’s not as scary as it sounds. Here’s how it works.

Let’s go back to our $15 stock example. Our initial margin was $22,500. Now say the stock moves up $5 in the course of a month. You need to keep up the maintenance margin of 100% of the current market value of those 1,000 shares, plus at least 25% of the total market value of those shares.

Since the stock we sold short is at $20, the shares currently go for $20,000. So you’ll need that much money in your account., Plus you need to add 25% of $20,000. That brings your maintenance margin to $25,000.

Your broker will issue a margin call of $2,500. If you don’t make the payment, and you have other securities in the account, your broker has the option to sell those stocks to pay off the margin. And you don’t have a say in which ones he sells.

One way to avoid a margin call — and the only way to take profits — is to cover your position by buying shares on the open market. Just be careful that you don’t make a mistake.

How to Cover

Believe it or not, you can end up owning a stock and shorting it if you are not careful with your instructions to your broker. When you call or go online to cover a short position, specify that this purchase is to cover the open short position. If you do not, you could end up buying the shares — which will be sitting in your account, while you have an open short position at the same time.

Since you may be exiting your shorts in a hurry, it’s worth it to take the time to insure you issue clear instructions to your broker. That way you’ll get out exactly when and how you want to!

Let’s finish things up with a look at risks you should be aware of….

The Reality of the Short-Squeeze

One of the biggest risks short sellers face is a short squeeze.

A short-squeeze occurs when the price of a stock rises quickly, prompting investors who are short to cover their positions as soon as possible. 

So many people suddenly buying shares generates higher prices, instigating other stock holders sell to take a profit. That leads brokers to call in more loans, which then forces many short-sellers to buy back more stock. And so on. 

This sudden and necessary forced-buy frenzy can really wring the profit out of your investment.  The main protection you have from that is to avoid a stock that has massive short interest. Sometimes a market event can trigger a short squeeze, other times traders who note a huge number of short players are in the market will attempt to create one.

One way to protect yourself is to only play stocks whose short interest — the total number of shares sold short — is low. Keep in mind, that number is relative. Three million shares short is a big deal for a company with 10 million shares, trading under 1 million shares a day, but not so big for a company with 100 million shares outstanding, trading several million shares a day. 

There are many financial sites offering short interest statistics. If your favorite site doesn’t, use Google to find one that does.

Even When You’re Right, Could Be the Wrong Time

No matter how good a player you are, you can’t expect to hit a home run in every at bat. Your analysis can be spot on, but the timing isn’t always right. Even when a company is blatantly overvalued, it can still take time for investors to come to their senses and knock it down to size. The market never promises to be rational, and emotional commitment to stocks from private and institutional investors takes time to chip away.

Don’t Count on Dividends

There’s one catch about shorting shares…you have to pay back the dividends. You’ll receive the dividends from the company you’re shorting, but you’ve got to pay back that amount in full to the original owner.

Stock Splits Are Nothing to Worry About

Stock splits aren’t a big deal at all, it just adjusts your cost basis. Let’s say you sold short 100 shares at $34, and the company announces a two-for-one stock split. Now you’ve got to cover your short with 200 shares. But here’s the thing: we’re talking twice as many shares, but they’re only worth half what they were before. So your adjusted cost basis is just $17 after the split.

A Quick Word on Taxes

Even if you hold a short for more than a year, the IRS still considers these “short-term gains.” But say you were keeping a short open for two years, and buy to cover, the gain or loss is still “short-term.” This actually makes sense. Think about it. The only time you actually “held” the stock was between when you bought the stock to cover the position and when you actually delivered that stock to actually close the position out. That time is as short as a few minutes or as long as a few days at most

There’s only one exception: if you deliver stock held more than one year to cover the short, that’s a long-term gain — no matter how long the short position was open.

Remember that when the short position is finally closed out, the brokerage house will not make any indication on that year’s 1099-B form, but that’s the year when you have to report the gain or loss realized in the transaction.

Now, as I’m sure you know, short-term gains are taxed as ordinary income. Therefore, the nominal tax rate is tied to the tax bracket you are in. More explicitly, it will be taxed at the federal tax rate as determined by your taxable (not gross) income line on your federal tax return.

Turn Falling Stocks into Cash

Those might seem like a long list of risks and things to keep in mind. But the more important thing to remember is that these risks are easily mitigated just by paying attention.

If you carefully choose which stocks to sell short — using the criteria I’ve laid out — you’re less likely to see a position move against you. If you pay attention to short interest and the stock’s price movement, you’re less likely to suffer a short squeeze. And if a company is in trouble, it’s less likely to pay dividends — meaning you shouldn’t have to worry about them.

Armed with this knowledge, you have a powerful tool for making money if stocks start diving into a bear market.