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We all make investments in the stock market to make money. A common goal of most small cap investors is to purchase a stock that has not yet reached its full potential, a possible diamond in the rough. Companies that boast the newest technology or cutting edge products are usually where we look for the best opportunity. Normally investments are made based on the belief that something positive is going to take place in the future that will increase the value of a stock. When we sit back and evaluate the stock market, it is really nothing more than a forum for legalized betting. Investors bet that a company is going to increase in value.
In any transaction there are two parties, someone who believes the company results will be positive and increase in value, and the another party who believes the performance of a company will diminish and reduce in value. Investors can choose to take either stand. It is easy to bet on a company, we simply buy the stock. When investors bet against a company’s success it is called shorting or taking the short position.
The whole concept of shorting stock is confusing to people because it breaks the forward train of thinking by adding another dimension to the bet. The normal train of thought would be, “Don’t buy the stock if you think it is not a good investment.” But the concept of shorting gets more detailed in its objective, short sellers are also betting that they can get the investors who initially bet that the stock would increase to change their position. This negative volume creates an imbalance in the market and forces the price of the stock down.
Every year billions of dollars are made and lost by investors taking a short position. The advantage to short selling is that investors do not need a lot of capital to make these investments, they open what is called a “Margin account.” A margin account allows investors to borrow stock from an investor account other then their own. The transaction takes place in several calculated steps; the stock is borrowed and immediately sold. The investor is betting that the stock value will decrease allowing them to buy the stock back at a lower price and return it to its original account. What most people do not know is that that borrowed stock could be their own!
While you are betting on a company’s success, another investor is borrowing your stock to take a “short position” This has a direct, negative effect on your investment. Because other investors react to the negative volume, or the selling, they also sell. If you do not feel like this is ethical, call your broker and request that they not lend out your stock or request a physical stock certificate for the shares you own (there is almost always a fee for this).
Although the “Short selling” of stock can be very profitable, there is a negative side. An investor can get into trouble rather quickly if the stock goes up. Besides having to pay a customary borrowing fee until the stock is returned, if an investor gets too far behind, the broker is required by law to make a “Margin call”. A short seller also can get caught in a short squeeze. Lenders of shares enjoy the right to call them back at any time. Multiple lenders have been known to call in shares of a stock all at once, thus forcing all the short sellers into the market to buy shares to cover their positions, which forces the price up rapidly in the classic “short squeeze.”
When shorting a stock, there are no secrets, investors must make it clear to their broker that they are shorting a stock. Investors must also determine a price objective. A price objective is an upward and downward cap on the movement of a stock. This technique is especially helpful in the event the stock skyrockets, limiting the amount an investor can lose.
Lets take a look at how the short sellers can affect the financial progress of a company. CEO’s tend to take it personal when traders who know very little about their company bet that they will under-perform. The process can create a volatile environment and at times be a false indicator of poor performance. For publicly- traded companies it is important that they constantly sell their concept to investors as a strong and powerful idea that will eventually air success. Reporting positive news and motivating investors with positive facts is what helps create an environment where existing shareholders remain confident and potential investors continue to show interest.
Many small cap companies are in the process of obtaining financing and the price of their stock is the determining factor of how their deal will conclude. Too often the performance of the company becomes secondary to defending the deflation of its stock price. “You spend your days combating allegations and answering questions to existing shareholders, this puts you immediately on the defense. There were days when I was personally buying stock in an attempt to cut the short position and show investors that management was still confident and strong.” explains the COO of one company.
It is unfortunate that actual performance may not always dictate stock price when the stock is being shorted. Firms are required to report their short positions as of settlement on the 15th of each month. A compilation is published eight business days after and can be found on www.nasdaq.com.
If you notice a short position is being taken on a company in your portfolio do not be so fast to throw in the towel. Quitting too early is what short sellers are betting on. They have created an uneasy feeling for existing shareholders that will test their loyalty. This possible misdirection could be a way of luring existing investors down the wrong path resulting in a loss for those who jump ship. Be confident in your investment and have up to date knowledge of your companies. There was a reason that you invested in a particular company before the short existed, those reasons are probably still strong arguments that the company will continue to operate and be successful.
