Selling stocks short is always a long shot
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I think that the stock market is headed lower; I believe the Dow Jones average will fall below 9,000 in the next 12 to 18 months. So I’d like to sell short some stocks, because if they go down, I can make a good sum of money. So please explain a short sale to me and tell me how to do it. I don’t want to take much risk, so I would prefer to short-sell companies that are really going to have earnings troubles, like Lennar, Beazer Homes and builders and suppliers.
C.T., Everett, Wash.
Dear C.T.:
There are 38.7 good reasons for the market to turn tail and “smoosh” to 9,000. The best I can tell you is that the market will always do what it’s supposed to do but never when it’s supposed to.
A short sale allows a speculator to make a bet (and hopefully a profit) on the declining price of a stock.
Assume a speculator believes that Lennar Corp. (LEN-$35), a $16 billion revenue home builder, will post lower profits in 2007. Well, most investors agree that the price of a stock is dependent on its revenues and earnings. Increasing revenues and earnings have a positive effect on a stock’s price, and declining numbers usually have a negative influence.
If the speculator is correct and LEN, which posted earnings of $3.69 per share last year, reports earnings of $1.50 per share this year, then there’s a good probability the stock price will decline. So this speculator borrows 100 shares from his brokerage and sells this borrowed stock at $35 to a buyer who believes LEN’s price will increase.
The speculator sold 100 shares he does not own; this transaction is called a “short sale.” This short sale at $35 creates a credit balance in his brokerage account of $3,500 and he’s “short” 100 shares, which must be returned at some time in the future.
It’s six months later. Behold and lo, LEN reports significantly lower revenues and earnings and its share price declines to $25. At this point, the speculator decides to buy back the 100 shares of LEN (this is called “covering” the short sale.). He uses $2,500 of the $3,500 credited to his account from the short sale six months ago and returns the 100 borrowed shares to his brokerage. Because the speculator sold the borrowed shares at $3,500 and covered them (bought them back) with a purchase at $2,500, his net profit is $1,000 ($3,500 less $2,500). It’s a big easy, straight as an arrow and sweet as a kiss.
There is an important caveat, though. If the speculator is wrong and LEN posts strong revenues and earnings, its stock could rise dramatically to, say, $55. At this point the speculator might wish to cover his short sale and buy back LEN at $55. Because the speculator only has a $3,500 credit from the short sale of LEN in his brokerage account, he has to come up with $2,000 more to cover this short. That’s a $2,000 loss. If he covers at $65, he has lost $3,000, and if he covers at $95, that’s a $6,000 loss. The potential loss is unlimited. Wow!
Meanwhile, unless you’re a seasoned speculator and have beaucoup bucks, it’s rather unwise to pick individual issues on your own. If you wish to do this, I suggest the following open-end and closed-end funds that specialize in short sales. I’m not recommending them, rather giving you a safer and more efficient alternative.
Short SmallCap600 ProShares (SBB-$64.04), Ultrashort Russell2000 Value Pro (SJH-$69.60), ProFunds Short Real Estate Investor (SRPIX-$23.87), PIMCO Stock Plus Short Strategy (PSSDX-$7.60), UltraShort Financials ProShares (SKF-$71.83), UltraShort Real Estate ProShares (SRS-$86.80) and Prudent Bear Fund (BEARX-$5.74).
Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net. © Copley News Service
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