Re: [A-List] Finance query

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Short Selling involves borrowing a security or commodity or currency futures
contract from a broker and selling it, with the understanding that it must later
be bought back (hopefully at a lower price) and returned to the broker.

Some investors feel they can better identify overpriced, bad companies than
underpriced, good companies.
Brokers and analysts focus on what to buy, not what to sell, so the good news is
more widely known than the bad news. When an analyst issues a sell recommendation
on a stock, they find it much harder to get information from the company's
investor relations department, and the analyst's firm would never get an
opportunity to raise capital or float a bond for the company.  If you discover bad
news, it might not yet be totally factored in to the current price of the stock.
Many institutions just won't do short selling, leaving unexploited short selling
opportunities for you to benefit from.  A portfolio which includes both long and
short positions in stocks which tend to move together will generally have lower
volatility than one which has only long  positions. Short selling is routinely
excercised by hedge funds, or risk management strategists.

But short selling is not a slam dunk. There are a lot of caveats:

To sell short, one has to first establish credit with a broker, or a counter-party
whop must be satisfied with the short sellor's ability to cover potential loss.
There's theoretically unlimited downside potential (i.e. if the stock keeps
rising, you keep losing). Most shortsellers set a limit to how much they're
willing to lose, but then they become vulnerable to a short 'squeeze', in which
long investors buy shares as the stock rises and demand delivery. As shortsellers
buy to cover their losses, the price continues to rise, triggering more
shortsellers to cover their losses, etc. This is a danger especially for small,
illiquid companies, or weak currencies The danger is that even if the stock is
overpriced, or a currency over valued, it may become even more overpriced, and you
will have to buy it at some point to cover your position. When you sell short,
you're not just betting on what the stock or a currency is worth, you're betting
on what the market will be willing to pay for the stock or the currency in the
future.  You're fighting the trend of the market, which is, in the long run, up in
an  growth or inflationary environment. When you buy a stock that you're confident
is greatly undervalued, you should feel content to wait as long as it takes for
the dividends to start rolling in (provided you have a sufficiently long
investment horizon), or the company does not file bankruptcy. When you're on the
short side, however, you will eventually need to buy the shares back, at whatever
the market price happens to be; and while you wait and wait for the speculative
bubble to burst, the rest of the market may continue on its upward trajectory.
SEC rules allow investors to sell short only on an uptick or a zero-plus tick. You
cannot sell a stock short if it is already going down. This rule is in effect to
prevent traders known as "pool operators" from driving down a stock price through
heavy short-selling, then buying the shares for a large profit.  Money from a
short sale isn't available to the seller, but is escrowed as collateral for  the
owner of the borrowed shares. You aren't earning interest on the money  (although
big institutions sometimes do, in the form of rebates).   You have to pay the
dividends that are earned.  You pay the (usually higher) short term capital gains
tax on your profits, regardless of how long you held the short position.  You
never know when another company is going to acquire the company you're shorting,
possibly at a significant premium. Sometimes shares aren't available to short.

Most short sellors mitigate the risk by setting strict quitting prices (say a 20%
loss per investment). If it reaches that limit, they must resist the temptation to
hang on, thinking it's even more overpriced now. Successful short selling is all
about timing, which makes it more like technical analysis than fundamental
analysis.

Some short-sellers target the following types of companies:
Small cap companies that have been driven up by momentum investors, especially
companies that are difficult to value.
Companies whose P/E ratios are much higher than could be justified by their growth
rates.
Companies with bad or useless products and services.
Companies riding the latest fad.
Companies that have new competition coming.
Companies with weak financials (bad balance sheet, negative cash flows, etc.).
Companies that depend too heavily on one product.

In October 1997, the HK markets collapsed as a result of its good liquidity -
investors were selling good HK assets to raise funds to meet margins on their
collapsed investments in the less liquid markets elsewhere in Asia. This
phenomenon is known as contagion. The tumult of the HK markets in August/Sept of
1998 was caused by the manipulation by hedge funds exploiting an overvalued HK
dollar pegged to the US dollar through a link mechanism which required rises in
local interest rates as HK dollars come under pressure from massive selling by
hedge funds which at the same time shorted HK equity in the futures markets. The
small size of the HK economy and its markets was ideal for manipulative foiling of
normal market forces.  For every 1,000 points drop in the Heng Seng Index
engineered by the hedge funds, they stood to profit by US$1 billion. The Heng Seng
index was pushed down from 10,000 to 6,600 before the government intervened with
US18 billion buying HK shares in one day. But not before the hedge funds took in
US$4 billion in one week.  HK has since change its trading reguklations to prevent
a repeat of the same manipulation by forbidding banks to lend to short sellors in
equity futures who simultanwously sell HK dollars.

Henry C.K. Liu




Rob Schaap wrote:

> Hi again,
>
> As this list seems relatively polite to its economic ignoramuses ...
>
> Let's say I'm short greenbacks (I've sold greenbacks I don't yet own, in the
> hope that on the date I'm contracted to cough up said greenbacks, they'll be
> cheaper than they are now relative to the currency I do currently own).
> Absent regulatory risk (eg persistent US government's commitment to low gold /
> high dollar), that's hardly a ridiculous position, after all.  The US current
> account is a persistent menace and we're seeing investment and profit
> shortfalls in the US economy.
>
> Now, regulation could be such that I'd have to prove I possess the money to
> buy the sold greenbacks were the greenback to appreciate.  But such regulation
> would be profoundly problematic, no?  I mean, no-one'd know how much I'd need
> in reserve, would they?  The Aus$ has plummeted 60% against the greenback over
> the last 20-odd years, for instance.  Who coulda seen that coming in 1980,
> when wool, steel, uranium and food still looked to be prime
> currency-sustaining commodities?  Who coulda seen I'd need reserves exceeding
> double the contract just to meet that contract?  How dead would you kill the
> finance sector if you were to require that kind of cover for every contract?
> And the Turkish Lira plummeted that far in the single year up to June 2001!
> And then there's the Argentinian Peso ...
>
> And what if I was big enough to control the share value of salient domestic
> stocks (you effectively control the Australian stock market if you own, say,
> 15% of each of NewsCorp, Telstra and BHP - and there are entities big enough
> to do just that).  What if I short the Aus$ and then promptly sell my 15%
> parcels?  Wouldn't I seriously lessen the worth of the productive assets that
> underpin the value of the Aus$?  Wouldn't capital flight (some of it to my own
> prettily positioned company) undermine the currency I'd shorted?  Wouldn't I
> have committed a fraud on (a) the entity who bought my contract, and (b) the
> Australian people?
>
> Is this what happened in SE Asia in '97?  Is this how Big Finance might
> protect its currently dodgy positions?  Would Australia then be paying for,
> indeed perpetuating the price of the greenback and the gambling of the big
> Wall St houses?  Is this how core-induced crises are geographically deflected
> - are imposed on the periphery?
>
> Apologies if I'm talking bollocks.
>
> Cheers,
> Rob.