A very brief overview of short selling…..

What is short selling?  Short selling is a widely used technique in which a stock is sold by a party that doesn’t actually own it, with the expectation that the share price will drop.  The shares sold are borrowed from a brokerage firm.  The short position is “closed” when the shares are bought back.  If the price has dropped from the sale price when the stock is bought back, a gain is realized.  If the price has risen, a loss occurs. 

What are the risks?   When you buy a stock at $10, the most you can lose is $10.  If you short a stock at $10 and it goes to $40, you have lost $30, or three times your initial investment.  With short selling the risk of loss is theoretically limitless if a stock sold short goes to infinity.   In reality, the main risk is based on the fact that stock markets and most stocks tend to go up over time.  Hence, the short-seller is swimming against the tide.   Short sellers in illiquid stocks are also exposed to sharp rallies known as "short squeezes" in which a short-seller may be forced to buy the stock at a significant loss.   

Our historical experience.   Short selling has improved our investment results, enabling us to generate positive returns during difficult years such as 2000 and 2001.  However, we believe our experience with this strategy has been positive primarily because our short selling has largely been limited to periods of significantly overvalued markets. 

Is short selling ethical?  Short selling is important to maintaining healthy markets.  Short sellers add liquidity to markets and help stabilize them.  When short sellers are covering their positions, it can actually stop a stock from falling precipitously.  Informed stock investors know that, from an ethical standpoint, short selling is neither intrinsically good nor evil.

Who can engage in short selling?  Short selling is prohibited in many accounts, including most notably tax-qualified accounts.