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 companyís 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, "Donít 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
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 companyís 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
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
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. CEOís 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