Current Market Fad Requires Taking Risk

September 16, 2008
Ed Rabinowitz

Physician's Money Digest, February15 2003, Volume 10, Issue 3

Nowadays, the term "short" is takingon a whole new meaning in the marketplace.Short-selling, particularly inthe current bear market, is a strategythat is becoming as hot as it is potentiallydangerous. Some consider it the pessimist'sapproach to stock investing.Whatever you call it, short-selling is notfor the faint of heart, and it is not astrategy to be casually employed.

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In its simplest terms, when you sellshort, you are really selling a stock thatyou don't own. According to(IDG BooksWorldwide; 2000; $16.99) byPaul Mladjenovic, CFP, to sellshort, you first borrow stocksfrom a broker, who lends you the sharesfrom their own inventory or borrows themfrom another customer or broker. Youthen sell the stock immediately on themarket, betting that it will decline in price,allowing you to replace the borrowedshares at a lower price and make a profit.

To help you better understand howshort-selling works, consider the followingexample. Suppose you borrowed 100shares of stock at $50 per share and soldthem. You would have $5000. Now, if theprice of the stock falls to $30 per share,you can buy 100 shares of the stock for$3000 and return them (called "covering"your position) to your broker, along withsome interest. The $2000 differencebetween what you sold the stocks for andthen paid to repurchase them is your profit.Sound simple? Be assured it is not.

Using the same example, if the priceper share rises to $60, you will have to pay$6000 in order to buy the stocks back andreturn them to your broker. In otherwords, you just lost $1000. If you wait, thestock may rise and you'll have to pay moreto purchase back the shares. Now, if youwere to simply take $5000 and invest it,the most money you could lose would be$5000. But with short-selling, in a worse-casescenario, potential loss is unlimited.

According to Mladjenovic, most short-sellersattempt to pick stocks that arefundamentally overpriced. This meansthat they pick stocks with high price-per-earningsratios, high price-to-book valueratios, and low dividend yields—stocksthat are exactly the opposite of what avalue-oriented investor would buy. Theaim is to identify stocks that will soonfall out of favor. This requires a lot oftime, research, and some strict rules.

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One of those rules is to start covering(ie, buying the stock and returning it toyour broker) if the price of the stock risesmore than 25% from the short-sell price.According to , you shouldalso consider a statistic known as shortinterest. This measures the total amountof shares sold short on a stock. If the shortinterest is high (eg, more than 6 times thestock's average volume), experts suggeststeering clear of the stock.

If you don't steer clear, you could findyourself caught in a short squeeze. Thisoccurs when a stock starts to rise sharply,setting off a chain reaction among short-sellersto cover their positions by buyingshares, which further fuels the stock's rise.Keep in mind, however, that most brokersrequire that you have at least 50% of thevalue of the borrowed shares in cash inyour account before you can establish ashort position. After all, brokers don'twant to get caught short, either.

If the strategy of short-selling intriguesyou, especially in today's bear market, butyou don't have the time to research anddevelop the disciplines required of thispotentially risky approach, there is analternative. There are a handful of activelymanaged short funds. You'll still be takingsome risks, but the fund managers andanalysts will do the homework for you.

Beware:

How do these funds perform? Onefund, the Prudent Bear (800-711-1848),realized returns of 66% through the first7 months of 2002. Over the past 2 1/2 years,the fund has been up 107%, comparedwith the S&P 500, which has fallen 30%over the same period. The fund,which was started in 1995, experiencedlosses in each of its first 4 years while themarket was posting huge gains. It's agood idea to realize now that there is noinvesting utopia.