Short Selling Perils
By S.P. Brown

Lately, many investors have turned decidedly bearish, which is understandable. After all, most market indices are now trading deeply in the red.

Leading this bloodletting has been the tech-heavy Nasdaq Composite Index (COMPX), which is trading off 32 percent from its all-time high of 5,028 set back on March 10.

Now, many former bulls are looking to make money on the downward momentum.

One of the simplest techniques to make a buck in a falling market is short selling. In a short sale, a stock is borrowed from a broker and then sold, creating a short position. Then, the position is reversed, or covered, when the stock is repurchased to repay the loan. The short seller profits if he's able to repurchase stock at a lower price than he received in creating the short position.

There are a few rules investors need to know about short selling. One, a stock can only be shorted on an up-tick. For example, a stock can be sold short at $51 1/8 if the transaction just before was at $51.

Investors also need to be aware of capital requirements, a point often misunderstood by tyro investors. Many people believe that since a short transaction starts with a sale, there is no need to put up any money or collateral. This simply is not true.

The investment necessary to execute a short sale is defined by an initial margin requirement that designates the amount of cash (or equity) the investor must deposit with his broker, which is currently 50 percent for equities. Thus, if an investor wishes to short $10,000 worth of stock, he must deposit $5,000 with his broker.

Unlike a long margined investor, a short margined investor does not pay interest on his borrowings, since he did not borrow cash, he borrowed securities. Still, he is responsible for paying any dividends that come due during the time his position is open.

Shorting can be a nifty device for protecting a gain in a long position. For example, if an investor owns a stock with a cost basis of $25 a share and it rises to $100, he can safely lock in his $75 gain by shorting the stock at $100.

However, most investors use shorting to speculate on a stock's decline, which is far from a riskless activity. If an investor were to short a $100 stock, the most he could gain is $100. On the other hand, his loss exposure is unlimited; theoretically, a stock can rise to infinity. Unlimited loss potential is what makes shorting individual stocks risky business.

Pragmatically speaking, though, a loss of infinity isn't going to happen. But huge losses can incur - and can incur shockingly fast - when a short investor gets caught in a short squeeze.

A short squeeze occurs when the price of a stock moves up sharply and investors with short positions are forced to buy the stock in order to cover their losses. This sudden surge of buying leads to even higher prices, further aggravating the losses of those short sellers who have not covered their positions.

The most famous short squeeze occurred in 1978 when legendary short seller Robert Wilson publicly announced (a big mistake) he had shorted 200,000 shares of Resorts International, which had just opened the first gaming casino in Atlantic City. Wilson reasoned that Resorts would not do well since Atlantic City's weather is not as favorable as that in Las Vegas. What's more, he believed that casinos needed Mafia muscle to collect debts, which Atlantic City had all but eliminated.

Wilson was betting that investor interest in Resorts would be tepid at best.

He couldn't have been more wrong. Investors fell in love with the casino. Soon after Wilson opened his position, Resorts quickly moved to $20. From there, it was straight up to $40, to $50, and then to $60 - all within a matter of weeks.

Now, the squeeze was really on as investors knew there was pent up demand for Resorts' stock because of Wilson's 200,000 short position. Many on Wall Street took perverse pleasure in pushing the casino's stock higher.

Finally, by early September, Resorts was trading at $190, meaning Wilson was in the hole $35 million, which is where he eventually covered.

The moral of this fable is that investors considering shorting this market would be well advised not to put all their eggs in one basket. To be safe, an investor should spread his shorts over a minimum of 10 different stocks, or short a market index, such as one of the many that trade on the American Stock Exchange.

As Robert Wilson has proven, even the most-savvy short seller can lose it all when just one sale goes against him.