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September 2006

In today's bulletin, we discuss Short Selling Strategies. The first section is a column produced by André Gosselin, vice-president of Orientation Finance and financial columnist for Affaires Plus magazine, Web portal lesaffaires.com, and Finance et Investissement. He holds a doctorate in political science from the Université du Québec à Montréal and was an associate professor at Laval University from 1990 to 1997.

Mastering short selling
Investors in their early days of stock trading are always astonished to learn they can sell shares they don’t actually own but have borrowed from their brokers. They just have to buy them back later in the hope prices have fallen, hand the shares over to the broker, and pocket the difference.

With markets down in 2000, 2001 and 2002, the few investors who made money were those who were not afraid to sell short, in other words to bet that a stock would go down. Imagine the gain you could have made by shortselling 1,000 Nortel shares when they were trading at $100 in Toronto and buying them back at $3 some time in early 2003.

Since the market is still high and bargains are rare, short selling clearly remains a tool that investors have an interest in mastering if they want to draw the best advantage.

Despite problems of moral conscience that short selling may pose for certain investors, I remain convinced this practice is useful and even necessary to make stock markets work more efficiently and less exuberantly. Short selling helps reduce the size of the speculative bubbles that afflict markets from time to time, as was the case in 1987 or the late 1990s.

Nobel prize-winning economists such as Milton Friedman have emphasized the basic role short sellers play in helping financial markets, particularly stock markets, function smoothly. Short selling is viewed not just as a legitimate way of diversifying portfolios but also as a technique for making markets more efficient and better able to play their role of valuing financial assets.

Only a handful of studies have been written on the yields provided by short selling. Most show that this investment strategy as practised on U.S. markets is profitable. According to researchers, investors who engage in short selling are more competent and better informed than average, as shown by the yields on their portfolios.

The two most interesting and thorough studies I know of cover the American and New York Stock exchanges from 1976 to 1993 (Dechow et al.) and Nasdaq from 1988 to 1994 (Desai et al.). In both cases, the researchers showed that securities with the most short selling (in relation to volumes of outstanding shares) registered negative returns, thereby providing gains to short sellers.

Let’s not forget that short sellers achieved this in bull markets. Beware, however, that you may be correct about the mediocrity of a company or the exaggerated price of its shares, but the market has to share your opinion. Therein lies the real challenge.

Select your option
Selling put options in the context of a short selling strategy
Short selling consists of selling shares you do not actually own with the aim of buying them back later at a lower price and thus producing a profit. This strategy is risky, however. If the share price rises, you may incur a heavy loss. How can you protect yourself?

You can buy a call option and pay a premium that will give you the right to buy the underlying shares at a set price, or: you can sell a put option and cash in the premium immediately (in which case you may still be required to buy the shares if the buyer decides to exercise his put option).

Example
Mr. X anticipates that the price of ABC shares will go down. He decides to sell 100 shares short at a $25 unit price. A few days later, the share shows greater firmness and appears to be headed up. Not wishing to cover the cost of a call option, Mr. X decides to sell a put option at the $20 strike price, at a $3 rate. He thus gains a total premium of $300 (an options contract covers 100 shares of the underlying value) and is committed to buying back ABC shares at $20 should they trade below the $20 threshold. This sets his buying price at $20, thereby limiting his potential profit.

Scenario 1: The share price falls below the $20 threshold.
If the price of ABC shares falls below $20, Mr. X will face a payment call and will have to buy back the shares at $20. Mr. X’s profit will be $8 per share ($25 minus $20 plus the $3 premium). In this instance, Mr. X will be considered to have paid $20 to buy back shares sold previously at a price equivalent to $28.

Scenario 2: The share price stabilizes between $20 and $25.
If the price of ABC shares stabilizes between $20 and $25, Mr. X will not face a payment call and will not have to buy back the shares, but he will still be subject to short selling rules. At the maturity of the option enabling him to cash in a $300 premium, Mr. X can choose whether or not to sell a new put option.

Scenario 3: The share price goes above $25.
If the price of ABC shares rises above $25, Mr. X will not face a payment call, but the firm could still require him to buy back the shares following a margin call or a share recall by the lender. Mr. X will make a profit from his short selling as long as the share price remains under $28. In effect, the premium he receives in selling the option is equivalent to selling his ABC shares at a rate equal to $28. If the share price continues to rise above $28, Mr. X will suffer a loss if he is required to buy back the shares or pay an extra amount to cover his margin.

The sale of a put option does not provide the investor with either insurance or perfect protection, as is the case with a call option, for instance. Together with the short selling of shares, however, it does provide for a higher average selling price for shares submitted to short selling. In the abovementioned example, Mr. X increases his short selling price from $25 to $28. It is important to note that the sale of a put option has repercussions on the margin available in your account. The premium that has been received must remain in the account until the option matures or is bought back. As well, this option will be regarded as uncovered because of the risk linked to a potential share recall by the lender.

*Investors should review the document that describes the risks inherent in negotiating options. Options are not suitable for all types investors.

Previous Newsletters

• July 2006 - The Swiss Army Knife of Investment Tools
• June 2006 - Support & Resistance Basics
• May 2006 - Writing Secured Put Options
• April 2006 - Understanding Market Depth
• March 2006 - The Momentum: the most classic indicator
• February 2006 - Fibonacci and the Golden Ratio
• November 2005 - History of candlesticks charting
• October 2005 - How to Read Gaps: An Introduction
• September 2005 - Using Bollinger Bands
• August 2005 - The MACD – An Introduction
• July 2005 - How can you spot changes in trends ahead of the crowd?
• June 2005 - An application of the Langford forecasting method
• May 2005 - In-The-Money, At-The-Money or Out-Of-The-Money Calls
• April 2005 - Synthetic Option Strategies