SHORT SELLING

First, what is a short sale? It is an attempt by an investor to make money when a stock goes down. It essentially starts with a margin account where the investor borrows a stock and the sells it. Now, he/she doesn't get the money- in fact has to put up some money in the margin account to show "good will". If the stock should go down, the investor buys it at the lower cost and replaces the 100 shares.

Example, assume you borrowed 100 shares of ABC worth $50. You sell it and put $5,000 in your account. What you must do at some point in time is replace the 100 SHARES of ABC, not the $5,000. Assume the stock went to $25. It would cost $2,500 to replace the 100 shares. Net profit = $2,500. If the stock goes up, a problem since the investor will have to buy the higher priced stock in the marketplace and hence a loss can be suffered. If the investors already has the stock he does a "short against the box" and can protect the investment in case it is going down. Obviously, if the stock goes up, he already owns it and can easily replace the short position.

The old theory goes that the more short selling on a stock that exists, the more favorable long term outlook exists since investors will have to buy back their positions later on. So it's a bull position. But a study by professors at MIT and Harvard say that the old position is absolutely not true since companies with high short interest tend to have serious flaws that haven't yet been publicly disclosed and will generally underperform the rest of the market. The study reviewed the time frames from 1976 to 1990. They found that an investor who shorted stock that already had the highest short positions would have outperformed the leading market averages by an average of up to 1% per MONTH- a huge advantage. The study underscored the fact that short sellers are among the hardest working, most persistent and most perceptive investors around. They are astute at detecting companies who falsify their financial results and boast too optimistically about their products and prospects. Therefore, "if you own a stock with a high short interest, the clear and strong advice is to sell the stock now". "The average returns from continuing to hold the stock are clearly negative." And for the technicians out there, it appears that the use of stock options as a hedging device did not materially alter the findings.

1997 TAX LAW CHANGE: Congress did not like shorting against the box since they did not get any tax because the stocks did not have to be sold. The change is that gain is now recognized when you sell the borrowed shares. How this will affect the returns as identified above, I don't know.