MARKET COMMENT
By
There seems to have been an explosion of interest in the technique of "shorting" over the last year or so. Our discussion boards are full of people talking about doing it themselves or about the effect that "shorters" are having on a share price (whether real or imagined). Even the Rule Breaker portfolio on the US Fool is getting in on the act, with its recent decision to short Affymetrix (Nasdaq: AFFX). In its literal sense, shorting is the exact opposite of buying a share. Starting from a neutral position, with no shares, if you then sell some, you will have a shortage of them, more commonly known as a "short position". This means that, at some stage, you will need to buy the shares back, to re-establish your neutral position. In the meantime, you hope that the price has gone down, so that the shares you buy are cheaper than the ones you sold. It sounds as though the only real difference is the order that you do things in, but it's a very fundamental difference and it causes some big problems. First of all, shares tend to go upwards. The market tries to price them so that they provide an ongoing positive return. In fact, to compensate it for taking risk, the market tries to price them to provide an ongoing return that exceeds the returns that are available from cash. By taking a short position in a share, you are in the opposite position to the buyer. You are betting that cash will do better than the shares and this is not entirely unlike pushing water uphill. You might be able to do it a bit, from time to time, but it's not the natural order of things. It's also the case that companies have to be owned by people. There has to be a net long position and, just as buyers chasing too few shares can chase a share too high, sellers running away from too many shares can cause a share price to be artificially low. As more and more water gets pushed up the hill, the greater the pressure for it to come down again. It's possible for some people to make some money on the way, but its storing up trouble for the shorters as a whole. The most important point to bear in mind about shorting, though, is that it exposes you to potentially unlimited losses, while your maximum gain is limited to the amount you sold the shares for. Again it's the opposite of the buyer's position. Shorting is a risky game. You can be as certain as you like that a share will go down, but it can still go upwards, it can do it very quickly and it can stay there long enough to wipe you out. If you do choose to do some shorting, and I would strongly advise against it (if you hadn't noticed), then you need to watch your position very closely, operate tight "stop losses" and stick to them religiously. Otherwise, when that wipeout moment comes, you could just get wiped out. If you really want to take a bet on a share going down, it's probably best to consider using put options. That way, at least you know the extent of your possible downside from the beginning.
