Shorting the Market

In light of the recent temporary ban on short selling a number of companies in the U.S., I have had several questions from subscribers on what short selling is all about.

I have used short selling for years to make money when the markets are in a downtrend and falling. To many people it seems "strange" that you can make money while the markets fall but through the use of shorting either stocks or a stock market index you can do so with some success.

The concept of short selling is as follows:

You have 3 players in any market transaction; the buyer, the seller and the broker. This deal will involve me, my broker and someone on the other side of the trade (we'll call him "Mr. Wrong").

-I decide I want to short "XXX" company as I believe it is overvalued and due for a market price decline. The share price of XXX is currently trading at $100/share on the open market.

-I go to my broker and ask him to lend me 100 shares of XXX. He checks his account and determines he does hold shares of XXX within the brokerage firm. He also checks my account to make sure I have enough money in my account to back up those shares.

-He agrees to lend me the shares (if he didn't have the shares in his account but offered to lend them to you anyway, that is known as a naked short sale and is technically illegal although it routinely takes place).

-I take the shares he lent me and put them on offer in the market (my broker collects a commission on the trade).

-Mr. Wrong is looking to buy some shares of XXX because he thinks they are a great company and expects the stock price to increase. He sees my 100 shares on offer for $100/share and buys my 100 shares for a total price of $10,000.

-He collects the shares from me and I collect the $10,000 from him for the shares (in fact, this is technically incorrect as he doesn't really collect the shares; they are electronically transferred into his account and the money is electronically transferred into my account).

Three weeks later XXX has a profit warning and the stock price falls 50%. Mr. Wrong now wants to sell his stock as he does not want to lose any more money. He puts his 100 shares for offer in the market for $50/share.

-I decide XXX has found a bottom so I would like to cover my short position. Through my broker I go into the market and buy Mr. Wrongs 100 shares at $50/share (my broker collects a commission on the trade). I pay Mr. Wrong $5000 and he gives me the shares back.

-I then return the shares I borrowed to my broker.

Net Result:

-Mr. Wrong lost $5000 on the transaction (he bought the shares for $10,000 and sold them for $5000),

-I made $5000 on the transaction (I received $10,000 from Mr. Wrong initially and only had to pay him back $5000), and

-My Broker made a commission on the 2 transactions for acting as the go-between.

This is how you make money shorting the market.


However, the opposite occurs if you end up wrong. If I shorted XXX and instead of going from $100 to $50, it instead goes up to $150/share here is the transaction:

1) I borrowed the shares of XXX from my broker
2) I sold those shares to Mr. Right (I collect $10,000 and he gets the 100 shares)
3) XXX reports a great quarter and the stock price climbs to $150.
4) I decide to cover my short (this is known as a "short squeeze") and Mr. Right decides he wants to sell his shares.
5) I pay Mr. Right $15,000 for his shares, he gives me the 100 shares of XXX back.
6) I give the shares back to the broker.

Net Result:

1) Mr. Right made $5000 on the trade (he paid $10,000 for 100 shares @ $100/share and received $15,000 for the 100 shares @ $150/share).

2) I lost $5000 on the trade (I initially collected $10,000 from Mr. Right but had to pay him back $15,000 to get the shares back) .

3) The broker made 2 commissions on the trades acting as the go-between.


The key is to know when it is right to be short the market and when it is not right. When the market is in a general uptrend (as it was from 2003 to 2007) it is generally quite dangerous to short the market (you are attempting to go against the overall trend). Long trades work best.

When the markets are in an overall downtrend (as they are now), it is quite dangerous to go long the market as the trend is down. Short trades work well.

Case in point is the chart below of the Profunds UltraShort S&P 500. This fund is both a short fund and is geared (leveraged) to provide two times the performance of the underlying S&P 500 Index. In other words, not only does it gain in value as the S&P 500 Index rises in value but it does so at twice the rate at which the SPX falls.

Click on the chart to enlarge:





Since the October high in the market (the dotted blue line is the S&P 500 Index) this fund has returned 48.3% during the time the S&P 500 Index has fallen 23.02%.

This fund (and there are similar funds that cover most of the major stock market indexes) is not for the weak hearted but I use it in my personal account to maximize returns in down trending markets.


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