Alternative Investments

Hate a Company? Don’t Get Mad, Get Short

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There’s a huge difference between the typical sports fanatic and the average investor: One stays glued to the screen, screaming, yelling, drooling and rooting for favorites while cursing foes. The other is a sports enthusiast.

Whoever said there’s no emotion in the world of investing never owned a single share of stock. Take the classic case of famous hedge fund manager and investing guru Bill Ackman. He’s so down on Herbalife International (NYSE: HLF), he considers the company to be nothing more than a pyramid scheme disguised as a corporation. He firmly believes the stock will come crashing down sooner rather than later.

Thus, Ackman has shorted the company’s stock to the tune of $1 billion. When and if it falls, as he predicts, Ackman stands to make a ton of cash. This is just one very clear-cut example of how someone can make money by betting against a company.

Activist Hedge Fund Managers

Activist hedge fund managers, like Ackman, seek to improve the companies they hold large positions in. (Taking a huge short position can hasten a company’s fall, which is apparently what Ackman is doing with Herbalife, which he believes the world would be better off without).

Familiar names like Carl Icahn, David Einhorn, and Dan Loeb are other activists. Einhorn has targeted Yelp Inc. and Allied Capital Corporation as “targets” for improvement, while Loeb has focused on Sotheby’s, Yahoo and Baxter International. Activist investors like these four and many others use their wealth to effect positive changes whenever they can. Many use short selling as one of many tactics in their arsenals.

How Short Selling Works

The textbook example of short selling is this: You believe (for whatever reason) that the stock price of company ABC is going to decrease beginning tomorrow. Today, you contact your broker and ask to “borrow” (for a fee) 1000 shares of ABC Inc, and sign an obligatory note saying you will repay the 1000 shares by X date. If your prediction is correct and ABC tanks from $100 per share to $50 per share, you would show a profit of $50,000, less the broker’s short-sale fee, say $250.

How did this happen? When you borrowed the 1000 shares, you immediately sold them on the open market for that day’s share price of $100, banking $100,000 in cash. Several days later, when ABC fell to $50 per share, you figured that would be a good time to repay your broker those 1000 shares you owe. So, you simply take $50,000 out of your cash account (which, remember, has $100,000 in it) and buy 1000 shares of the now lower-priced ABC. You then contact your broker and repay the 1000 shares. The broker also charges you $250 for the short-sale fee, and you’ve turned a nice profit of $49,750 but correctly predicting that ABC’s price would tank within a few days.

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Who Actually Shorts Stocks?

Individual investors short stocks every day, but hedge funds are the biggest players in the shorting game. A typical hedge fund manager gets paid a percentage of any profit the fund makes. If the fund shorts a million shares of XYZ, and the price subsequently declines, the manager and owners of the fund stand to reap huge fees.

But when fund managers are wrong, and the shorted stock’s price rises, the contributors to the fund take the biggest hit, while the managers typically lose nothing. Of course they won’t get a fee because there were no profits. Since the managers have no “skin in the game,” so to speak, they tend to take sizable risks with investors’ money.

The Advantages of Selling Short

As with any other kind of derivative (which is technically what short sales are), a short allows investors the chance to get lucrative returns without risking very much of their own money. Except for the fee you’ll need to pay your broker for lending you the shares, there’s no upfront expense.

Shorting is the only verifiable way for people to make money when a stock’s price (or the market in general) is headed south. If your guess is right that the stock in question will hit the skids, you stand to do quite well.

If you have a good relationship with your broker, and have a strong feeling that a stock is going to decline in price, shorting can be a protective strategy.

The Disadvantages

You might be wrong about the weakness of the stock price. If the price goes up, your broker can “call” you to cover (repay the shares) at any time. That means you’d be out the broker’s shorting fee as well as the price difference per share, times the number of shares you shorted. In a scenario where the price surges upward, the potential monetary damage could be infinite.

Some economists, but not all, say that shorting is bad for the market because it magnifies downturns in stock prices. If XYZ drops 2 percent in price in one day and 10 million shareholders immediately short it, that puts extreme downward pressure on the price and could cause a market crash in a given sector, theoretically.

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This “shorting is bad for the economy, the market and individual companies” theory is controversial. Believers point to the Bear Stearns fiasco/wipeout in mid-2008 as proof that shorting can magnify a normal downturn and bankrupt a company. Later that same year, similar situations beset Fannie Mae, Freddie Mac and Lehman Brothers, setting the “crash of 2008” into full swing.

How to Succeed in Shorting Without Really Shorting

If you like the idea of betting that the market, or a particular sector, will decline in price, there are other ways to make a profit on the downturn. The “shorting concept” is at work in a wide variety of “inverse ETFs.” These financial instruments work just like normal ETFs except they are inversely tied to the market or segment they track.

For the iron stomach crowd, there are also leveraged inverse ETFs, which double- or triple-track the downturn. Suppose you purchase one of the more popular (of many) leveraged inverse ETFs, like Pro Shares Ultra Pro Short S&P 500 (SPXU) at $12 per share. You purchase 1000 shares for $12,000.

You would only do this if you expected the S&P index to fall. Theoretically, the basket of securities in this ETF responds inversely to the index, and does so at 3 times the change. So, tomorrow the S&P has a terrible day, for example, and falls by 3 percent. Your ETF shares in SPXU would, theoretically, increase by 9 percent, at which point you sell and pocket the $1,080 profit (3 percent times 3 = 9 percent. Nine percent of your $12,000 investment is $1,080), less brokerage fees. Not bad for a day’s work.

Remember that the leveraged ETFs don’t always hit their tracking targets, so will sometimes deliver more or less of the stated multiplier. For more risk-averse investors, there are inverse ETFs that are not leveraged, so you’re essentially shorting the market or sector represented by that particular ETF, as you would an individual stock.

Note: We’re not financial advisors here, and this article is offered only as educational background for curious readers. If you decide that you want to invest in anything, or use short selling as a means to make a profit in the stock market, consult a professional. Everyone’s financial situation is different, so always be sure to get expert advice before putting your hard-earned money on the line.