White Top View series on Short Selling, Part 6
Only the right costs and prices can profit short sellers
Today we discuss the prices and costs short sellers need for a profitable trade. This discussion continues as Part 6 in the White Top View series Short Story on Short Selling. In Part 1, Novice investor asks, “Explain selling stock short”, we opened our series of discussions on selling short.
In Part 2, Investor, is a stranger selling your stock?, we continued by explaining that short sellers must borrow stock. So they could be selling stock that you own!
Part 3, Investors must know the short story, discussed short selling sophistication and why they usually target large companies.
Part 4, Nine things investors selling short must know, introduced the 9 factors that need to be considered and discussed the first two factors, Market facts and Corporate facts.
Part 5, Short sellers need judgement, vision and timing, covered the next three factors, 3. Industry facts, 4. Market response and 5. Timing.
Here in Part 6, our discussion continues by covering costs and prices.
All costs and share prices matter when selling short and include transaction costs and fees, selling share price realised and finally the share price when buying to close out the short position.
Costs, all costs
Short fees including interest costs or the equal, transaction costs and possible costs of paying any dividends. All need to be considered. Short selling costs tick on or add up each day the short seller carries a borrowed or open stock position.
Remember the short seller has to find and borrow stock before selling it. Just as the short seller considers the transaction to make money, so is everyone else that aids or facilitates the transaction. The short seller pays them all.
Also be aware that should the shorted stock be a dividend payer, all costs associated with paying the dividend and the dividend itself comes from the short seller. Remember, the short seller sells stock they do not own. So should any dividends be due while the short position remains open, the short seller must pay that dividend.
Dividends can take a big bite. And there is no opportunity to recover that sunk cost later. The dividend paid by the company being shorted goes to the owner of the shares that got sold by the short seller.
Those are borrowed shares so the short seller must pay the dividend to the account that the shares were borrowed from. The short seller stands on their own. They pay all costs.
Dividends are one factor that can be a very significant cash cost to a short seller. This is especially so if timing the short selling is significantly off. Worse yet, if multiple dividend payments are needed.
The broker loaned stock borrowed from another account. The owner still has the right to, expects, and gets their dividend payments without any interruption or risk.
The cost of those dividend payments immediately come directly from the account of the short seller on the due date. In cases when the account has insufficient cash it forces the sale of other assets or any unrelated shares to produce the cash.
The share price, both when short selling to open the position and when buying back the shares to close the position, must be in the short seller’s favour, to make a profit. Before opening the position, the shares of the target company must be trading at prices significantly above what the short seller believes is the real or true value of the shares.
The short seller needs a buyer for what they believe to be an overvalued stock. That means any viable short candidates must have relatively high ‘overvalued’ stock prices.
In practical terms the potential for both substantial and downward price movement must to in place. That means never considering low-priced stocks as potential shorts. Even when bad news can drop such a stock price considerably lower.
Obviously if the market knows or anticipates bad news the price will already be discounted. That limits the downside and means forgetting about shorting such a stock.
There has to be significant and continuing volume of shares being exchanged for any potential short target to be attractive. Never short a low volume stock. Both when selling the high priced shares to open the position and when buying back lower priced shares to close the position, volume must be there.
Should volume dry up at either end of the short sale transaction, there is an immediate and big pricing/cost problem. Forcing either transaction by chasing the market down to sell or up to buy and close the position can quickly devour any profits. In worst case scenarios, profit quickly turns to unlimited running losses.
Should the short seller be wrong about cost or price factor, the transaction can become an unlimited financial horror story and money loser. Buying back the stock and repaying the loan provides the only way out.
The short squeeze
The worst case occurs when the short seller has got something wrong and the share price does not drop but rises. The short play is wrong and the price can build upward momentum.
The stock price can significantly rise as it moves against the short seller. Dividend costs just add to the financial pain.
Should traders know, realize or believe a large short position is wrong or ‘off-side’ a buying frenzy can happen. They can quickly descend like sharks on wounded prey knowing that the short must buy to cover and that will push prices higher yet.
Dramatic and rapid escalation in share prices can occur. That can force a short seller to cover to stop their losses. In one of the bizarre facts of market life, their buying adds to their financial pain. Their buying only pushes the prices higher yet.
When short sellers trying to close a short position and stock prices are rising, the short seller is experiencing the pain of a short squeeze. The classic short squeeze is not pretty for the short seller but party time for the longs!
Company management can declare victory and say the good guys won as they do some gloating. Few tears get shed for short that lose their bets.
Be careful out there
Without being reasonably correct about timing, a significant price drop and trading volumes, short selling transactions can be very expensive and financially unpleasant exercises.
Get it all right and taking a short position can quickly produce dramatic and considerable profits.
As has been said, short selling is not a strategy for a beginner. Don’t learn about investing by taking any short positions under any circumstances.
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These discussions and information intend to help you better understand markets and investing. I am not a financial or investment advisor; opinions are for informational and educational purposes only and are not intended as investment advice. For syndication of the site or blog, please contact info@WhiteTopInvestor.com.
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To read all parts of the White Top View series, the Short Story on Short Selling, click the links below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling
Part 12, Shorting stocks is hard