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Stock Picks Bob's Advice
Thursday, 29 December 2005
A Reader Writes "Could you give us a tutorial on shorts?"
Hello Friends! Thanks so much for stopping by and visiting my blog, Stock Picks Bob's Advice. As always, please remember that I am an amateur investor, so please remember to consult with your professional investment advisors prior to making any investment decisions based on information on this website.

Prudy, who goes by the name of Ydurp on Xanga, wrote me a nice comment and included a question. I want to comment on what she wrote and open up this discussion on short interest, and when to sell stock once again. Her comments:
Hi, Bob. I just listened to the Podcast and was pleased to hear my name. Well, it was backwards but it was me. Hey, I think I finally got it; the rationale behind your system. Two things drove it home. The first was your mention of greed:) And I have to say it's been all about greed for me. The second was your attitude about the long haul, how you were okay following the stock all the way up and then back down to your selling point because you had already taken your profits. Hmmmm, I finally got it: a kinder, gentler trader.

As always, I am grateful for your help. I have another question and it is about shorts. I watched Mad Money last night and the guy he interviewed was talking about shorts. I gathered people were betting on a stock's failure but the conversation was geared toward stocks that were good companies that didn't stay down. The focus, and this is where they lost me, was when the stock started to pick up. Could you give us a tutorial on shorts? Is it the same as puts and holds?
First of all, thank you for writing Prudy! And I thought your name was ydurp :).

Let me comment first on what you wrote about selling. I do believe that we all need to get over our "greed" in dealing with stock performance. When a stock appreciates, it is a happy moment for us. We feel vindicated by our decision to buy the shares. In face we feel "smarter" than the next guy. Heck, I love that feeling. In the same way, I hate to have that feeling of loss, literally, when a stock declines.

In my perspective, feelings quite interfere with our rational management of our stocks. When a stock moves higher, we either want to buy some more shares and really make a lot of money, or we want to sell the whole thing and cash in on the jackpot. Have you ever felt that way?

I think it is far more rational to sell a small portion of a stock that has moved higher, and leave the rest to appreciate some more if that is what the shares are going to do. Sort of like picking the ripe oranges off a tree (I just visited my brother in California who has a great set of navel orange trees....is that spelling correct?)

I sort of explain it like the guy that goes to Vegas to gamble at the slots. He (perhaps me..) arrives at the casino with a roll of quarters in his right pocket. He doesn't want to put all of his winnings right back into the machine, so he puts his winnings in his left pocket, only allowing himself to gamble with the right pocket quarters. I try to do the same when investing. Sort of keep selling off the gains, while leaving the original investment on the table. Do you follow?

As far as the "long haul" is concerned, I don't really know how long that will be. Sometimes I have a stock holding for only a day. Others I have held for years. It depends on how the stock performs. Not on how I feel about the company :).

In other words, if the stock doesn't hit any sale points to unload all of the shares (on "bad news"), then I shall continue to own at least a portion of my original investment.

Now let me review once again when I sell a stock on "bad news". First of all if there really is some bad news....like fraud, or product problems, or accounting irregularities, I might just unload my entire position on the spot regardless of the price movement. I always leave myself that out.

Otherwise, after purchasing a stock, I only let it decline 8% before unloading my position completely. If the stock goes past 8% on the loss, well I unload it as soon as I find out :). My son says I should be doing things more automatically. Once again, he is correct, and you might want to set up some automatic sales of stock; I continue to monitor this manually.

Other cases: if I have sold a portion of a holding once on "good news", that is, I sold 1/6 of my position at the first sale point which for me is at a 30% gain, then instead of letting the stock drop to an 8% loss, I sell if it retraces back to the original purchase price, the "break-even" point.

If I have sold a stock more than once, for example if I have sold a stock three times with the latest sale point at a 90% appreciation level, I allow the stock price to only retrace back to 1/2 of the highest appreciation level....in this case, letting it drop back to where I had a 45% gain, and then I would sell ALL of my remaining shares.

O.K....now to your question about shorts.

Short sellers do the opposite of what all of average folk do in regards to stocks. That is they actually SELL the stock FIRST and plan on BUYING the stock LATER to COVER their "SHORT SALE".

Do you follow? I don't sell stocks short, but will not rule out ever doing it in the future. Basically, when an investor or speculator buys a stock first, we are gambling on the possibility that the stock will APPRECIATE in value, so that we can sell the stock and pocket the difference. That is, we make money when the stock price goes UP.

Short-sellers do the opposite. Basically, they ask a broker to BORROW the shares from another account and SELL them. They pledge their own assets against this sale, promising to buy the shares back for the account that is missing the shares at a future date. Meanwhile, they are liable for any dividends the stock might be paying to the investor that has had his shares sold (unbeknownst to him or her :)). A short-seller who SELLS a stock FIRST and plans to BUY the shares LATER is gambling that the stock price is actually going to DECLINE. Since the short-seller could therefore buy the stocks back CHEAPER, he or she could thus pocket the difference and PROFIT from a stock's DECLINE.




Grandad's Bluff Post Card from the 1940's

One of the big downsides to short-selling is that the potential losses of a short-seller are INFINITE! That is if you sell a $5 stock short (you are "short" the sale because you sold it and didn't have any of you own to do so!), you could lose an infinite amount of money as the stock can climb as high as the moon! However, if you BUY a stock at $5, the maximum amount you can lose is just the purchase price (everything lol). But a short seller can lose a MULTIPLE of his investment. That is, if he short-sells a stock at $5 and it goes to $15, and he buys it back at that price, he has lost $10/share....more than the $5 original sale price.

I hope you follow :).

In my own evaluations, I often point out the "short ratio". This is a figure that I glean from Yahoo on the "Key Statistics" pages of each stock. This short-interest, which is usually several weeks old, tells me the number of days of average trading volume it would take for all of the shares that have been sold "short" to be covered. That is, if the short-sellers had to all buy back shares to return them to the original owners, the days worth of volume required. This is calculated by knowing the average trading volume of a stock and the number of total shares that have been sold short.

Personally, I use a three day cut-off for significance. This is an arbitrary cut-off that I set up in my reviews; I just needed some figure to distinguish what seemed to be a lot from a little in the number of days, the short ratio. I infer a bullish indicator from a lot of shares sold short. It is possible that the short sellers know something bad about the stock, which will result in the decline of the stock price. But in the face of good news, like a solid earnings report, or a new contract, etc., knowing that there are a lot of shares "pre-sold" so to speak, is imho, a bullish indicator that they might need to rush to cover to prevent their losses from mounting as the stock price moves higher.

When there are a lot of short-sellers out there, and the stock price moves higher, a "panic" might develop as all of the short-sellers rush to the exits. Which for them, means searching for shares to BUY to cover their pre-sold shares. This is called a SQUEEZE....and that is why I think it is bullish.

Anyhow, that was a pretty long-winded answer. I hope that was helpful. Please remember that I am truly an amateur, so my answer is from that perspective. If you or anyone else has questions or comments, please feel free to leave them on the blog or email me at bobsadviceforstocks@lycos.com.

Bob






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