Why Sell Short?
The two primary reasons for selling short are opportunism and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level. They believe that the stock price will fall when reality replaces the hype. A short sale provides the opportunity to profit from the overpriced stock. Short sales are also used to protect an investor’s portfolio against a market downturn. By shorting stocks that the investor believes will fall sharply when the market as a whole falls, investors can help insulate the value of their portfolios against sudden market drops.
Zitel provides an example of opportunistic short selling. In 1996, Zitel was caught up in a wave of investor enthusiasm because it has a stake in a company that fixes the computer glitch that causes computers to interpret dates in the next century (2000s) as dates in this century (1900s). This problem, known as the “Year 2000″ problem, suddenly became a hot topic of conversation and made it to the covers of Time and Newsweek. In September 1996, Zitel was selling for $7 per share. By December, the shares topped $70. At this point, many investors thought the stock was overpriced and saw an opportunity to make money by selling it short. If an investor had sold short in December 1996, he could have bought the stock back for $15 per share in April 1997. Selling short would have allowed the investor to take very profitable advantage of the opportunity presented by the overpriced Zitel stock.
Short selling is also used to protect portfolios against erosion due to a broad market decline. Short sellers make money when stock prices fall. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio’s returns and helps protect the value of the portfolio when prices are falling.
By shorting carefully selected stocks that are priced near their peak but that will fall sharply if the market falls, an investor can use the profits from the short sales to help offset losses in his long position to protect the value of his portfolio.
For example, Bob has most of his wealth tied up in stocks which she has bought because she expects them to appreciate in price. But she is concerned that the stock market is vulnerable to a sharp drop and wants to protect his savings while staying invested in the market. She knows that market drops are often caused by a change of investor sentiment from optimism to pessimism. She identifies businesses that are not worth much today, but whose stock price is high because people hold high hopes for their future prospects. These stocks should be especially susceptible to a negative shift in sentiment since optimism is what principally drives their stock price. She then sells these stocks short. If investors become more pessimistic and the market falls these stocks should fall more than most. Larry can use the profits from these short sales to offset losses in the rest of his portfolio. This will help to protect the value of his portfolio.
