Monday, August 20, 2012

Short Selling (2)

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We began exploring short sales in the last blog.  The short seller borrows stock which he or she expects to decline from a broker and sells them.  The short seller's brokerage account now has the proceeds from the sale.  Assume you sell 1,000 shares of a stock at $50 per share.  You now have a credit balance in your account of $50,000 (we'll ignore the fees, interest charges and commissions).  If, as you believe, the price of the stock drops to $30 per share, you buy the 1,000 shares in the market for $30,000 and return them to the broker.  Your account still has $20,000 in it.  That is your profit.  If the stock goes up to $60 and you decide to close out the transaction, you have to buy the shares you owe the broker at a cost of $60,000.  You have to add $10,000 to the $50,000 in your account to complete the purchase.  The additional $10,000 deposit is your loss.  

One of the most famous traders, Jesse Lauriston Livermore, wrote a book about his trading experiences and methods in 1940, How To Trade in Stocks.   Livermore explained in his book why he engaged in short selling as follows:

There is no good direction to trade, short or long, there is only the "money making" way to trade.  But the stock market moves up roughly a third of the time, sideways a third of the time, and downward a third of the time.  If you only played the bull-side of the market, you were out of the action, and a chance to make money two thirds of the time.

Livermore emphasized the fact that a trader, whether short or long, had to pay constant attention to the trend of a stock, not its price.  He explained his strategy as follows:

One should never sell a stock (he means going short), because it seems high-priced.  You may watch the stock go from 10 to 50 and decide that it is selling at too high a level.  That is the time to determine what is to prevent it from starting at 50 and going to 150 under favorable earning conditions and good corporate management.

Conversely, never buy a stock because it has had a big decline from its previous high.  The likelihood is that the decline is based on a very good reason.  That stock may still be selling at an extremely high price relative to its value -- even if the current level seems low.

He followed the stock's price trend, not its price level.

Although not legally correct, the old lines of Wall Street doggerel succinctly sum up the lesson to be learned by short sellers:

                                         He that sells what isn't hisn
                                         Must buy it back or go to prisn.

I think that short selling is best left to market professionals speculating throughout the day in the market.  It is not a game for amateurs trading on a part time basis.

Excerpts from How to Trade in Stocks, Jesse Livermore, copyright 1940, published by McGraw Hill in 2001 with updates and commentary by Richard Smitten, pages 12 & 144

Comments are always welcome.

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