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Selling Short - Different Reasons to Sell Short

In a short sale, you do the selling first and then buy back later. If prices are lower when you buy back, you have a profit. If prices are higher than when you sold short, a loss occurs.

If you do not want to sell a portfolio, but feel that stock prices will be declining over the near future, a trader can sell a futures contract, buy a short mutual fund, or utilize a ETF (exchange traded fund) in the amount of his portfolio. A hedge can be total, meaning equal the amount of the portfolio, or for a portion of the portfolio.

This past week (8/22/05 to 8/26/05), many stock indexes closed below their 50 day moving average. There will be traders shorting the indexes for profit and for hedging of their portfolios. If stock indexes continue to decline and drop below their 200 day moving average which is below the 50 day moving average for most indexes, I believe you will see additional short selling for both positions and hedging of portfolios.

There is no guarantee that short positions will be profitable. There have been people shorting home building stocks for years as they have gone higher. Remember, that if a short sale starts losing money, the short seller will be asked to come up with more money to hold positions. Many times these short sellers have to buy back before they would like to do so, causing the stock or index to just keep moving higher and against the group of short sellers. Eventually, short sales must be closed and that sometimes lends support for the stock. When short selling combines with long liquidations, a stock or index can decline quickly.

Short interest in home builder Toll Brothers, TOL is at high levels. Many other home builders are also at high short sale levels. Google, GOOG has been a favorite of short sellers. Both GOOG and TOL recently moved below technical areas that may bring on both new short selling and long liquidations.

If you are using short selling of an index as a hedge and the index rises, your loss in the short sale is made up by the gain in the index. You just will not have the gains in the portfolio that you would have had if you were not hedged.

If you use the short sale as the entire position, you need the stock or index to decline to make a profit. If it goes up, a loss will be incurred.

A good example of using a short sale as a position in a spread that is out of line would be in the current interest rate environment (in the year 2005). The yield curve is getting flat and may even invert. A trader may sell short longer maturities and buy short maturities. The current 10 year rate is about 4.17, while the 30 year is about 4.37. Buy selling short the 30 year and buying the 10 year, a trader would be looking for the yield spread to go back to a normal range from this very small 20 basis point range for 20 years more risk in lending money.

Regardless of the reason you may want to use short selling, a stop loss should be used. Spreads get more out of line and home builders stock prices can continue to rise.

If the major indexes continue to decline, you will need to decide whether to exit positions, hedge all or a portion of your portfolio, or just sit and take it.