This is a style in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. The payoff to selling short is the opposite of a long position. A short seller will make money if the stock goes down in price, while a long position makes money when the stock rises. The profit that the investor receives is equal to the value of the sold borrowed shares less the cost of repurchasing the borrowed shares.
For example if 1,000 shares are sold short at $15 each and then put into that investor’s account. Let’s say the shares fall to $10 and the investor closes out the position. To close out the position, the investor will need to purchase 1,000 shares at $10 each ($10,000). The investor captures the difference between the amount that he or she receives from the short sale and the amount that was paid to close the position, or $5,000.
Essentially, the short-seller will “borrow” or “rent” the securities to be sold, and later repurchase identical securities for return to the lender. If the security price falls, the short-seller profits from having sold the borrowed securities for more than he later pays for them. However, if the security price rises, the short seller loses by having sold them for less than the price at which he later has to buy them. The practice is risky in that prices may rise without bound, even beyond the net worth of the short seller. The act of repurchasing a shorted security is known as “closing” a position or “covering”.
Pros: Stocks tend to go down faster than they go up. If the manager is right about his thesis, big gains can be had. Also short selling provides an investor with both hedges and gains that are not correlated with the market. Managers that tend to specialize in short selling are known for their painstaking, meticulous, and thorough research.
Cons: Since Wall Street is biased toward the long side, there is not much available research on short ideas. Managers must do their own or pay hefty fees to the few off Wall Street firms that specialize in this niche. Short selling also exposes investors to unlimited risks since a long idea can only go to zero and you lose everything you have invested. Stocks, though, can go up in theory an unlimited amount, so an investor is exposed to unlimited risk when a stock moves against you. Expected volatility of this style is very high.
An excerpt of “The Investment Survival Guide”