Wednesday, March 27, 2013

Short Selling

Short selling is selling an asset you don’t own at today’s price, because you believe you can buy it at a later date for a lower price.  For example SPDR Gold Shares (GLD) is an Exchange Traded Fund (ETF) that holds $64B in gold bullion.  Today gold is down 0.4% and GLD is down 0.36%.  You can sell GLD at $155.68 today and buy it back down the road at a lower price and make some money.  You are also earning interest on the money you collected by selling GLD. 

What could possibly go wrong?  Gold may go up.  In turn GLD will go up.  If gold goes up 10%, and you sold 1000 share of GLD at $155.68, GLD may be running at $171.25 and you are on the hook for $15,568 dollars.  If you don’t have that money in your margin account you will get a margin call.  If you cannot meet the margin call, your account will be liquidated.  When you open the position the margin required is 50% of the sale or $77,840.  If you have $90,000 in your margin account, you will get a margin call when GLD hits $180.01 as you no longer have 50% margin and your position will be liquidated.

When the underlying asset starts rising, you are facing a “short squeeze” which is a temporary blip that drives the price of the underlying asset up while short sellers try to cover their positions.  They are trying to buy at the new high price, which drives the price even higher.

Short selling can be an attractive way to invest without the vagaries of general economic fluctuations.  Say you want to invest in airlines and love Southwest (LUV), but hate United (UAL).  You could go long LUV and short UAL.  If the market tanks, both will go down, but hopefully UAL will go down faster and you will make some money.  If the market goes up, both will go up, but hopefully LUV will go up faster and you will make some money.  This could be more attractive than buying the Guggenheim Airline ETF (FAA).

By the way you can do anything you want with margin, which is basically borrowing money to leverage your portfolio.  You can go purchase equities, bonds, commodities, options, futures and go long and short.  These strategies are often employed by hedge funds.  Risk management is essential with options and black swan events can wipe you out.  This caused a lot of individuals in finance to leap from their windows one dark day in 1929.

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