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Profiting from shorting stock

Saturday, January 28, 2006
So you may understand how the market works with a bullish outlook, but do not really understand how to profit from a bearish market. One of the tools of the grisly is to short a stock.

What does shorting mean?
Shorting a stock is basically selling someone else’s shares in a particular company with the contract that you will buy them back at a later date. When you buy back at a later date, this is called covering. You take your profit or loss at the point when you cover.

When the stock you took a position in goes up, you are liable for the increase per share since the time you took your position. If the stock goes down, you make the difference in profit. If there was a dividend paid during your position, you will be liable for paying back the original owner.

A Short Example
If you short 1,000 shares of XYZ at a current price of $25 a share and it goes down to $20 by the time you sell, your transactions will look like this:
1000 x $25 = 25,000 Initial Price
1000 x $20 = 20,000 Close Price
Initial Price – Close Price = Total
25,000 - 20,000 = 5,000 Profit

Now on the flip side if you short 1,000 shares of XYZ at a current price of $25 and it goes up to $30 by the time you sell, your transactions will look like this:
1000 x $25 = 25,000 Initial Price
1000 x $30 = $30,000 Close Price
Initial Price – Close Price = Total
25,000 – 30,000 = -5000 Loss

Liquidity of Shorts
One of the problems with shorts is that there is a potential of a “short squeeze.” This is when many investors cover their short positions and it causes the stock to spiral upwards. Often times these occur when news is not as bad as it was expected. To avoid short squeezes, watch out for stocks with high short interest as they have a higher chance of this occurring.

Short Interest is the number of outstanding shorts. This number needs to be compared with the average volume per day to have any significance. When you divide the short interest by average volume you end up with the number of days to cover the position. That means that if everyone tried to cover at once it would take that many days to close the position. You generally want to be in a stock with a low number of days to cover, since a high number of days to cover is usually associated with a short squeeze which will eat up potential gains, or create potential losses.

Warning on Liability
Since a stock can theoretically go up infinitely it is important to limit your liability in a short position, otherwise you could potentially lose your whole portfolio. Now, an infinite increase should not really every occur in reality but it is important to understand what could happen if the price goes from $25 to $100. You can limit your liability by placing an order for a buy stop at the price you want your liability limited at. This protects you from losing what you consider too great of a loss for your investment situation.