The first in a multi-part series of short-selling by Gil Morales and edits by Dr. Chris Kacher. Mr. Morales achieved roughly triple digit percentage gains at times such as in 2001 and in the flash crash of 2010. He wrote the book on short selling twice, once with William O'Neil then again in an updated version using daily charts with Dr. Chris Kacher.
Part 1: What is Short-Selling?
By Gil Morales, Managing Director
MoKa Investors, LLC
As the stock market continues higher in a never-ending QE-fueled upside grind, short-sellers have all but disappeared from the scene. But at some point, a new bear market will take hold, and short-selling will suddenly become a very profitable endeavor for those who catch the trend at the right time. But what is short-selling? Is it a more “sinister” side to investing, or does it serve a useful purpose? Let’s start with the basics.
Reduced to its mechanics, short selling is simply the act of identifying a change of trend in a stock from up to down and then seeking to profit from that change of trend as one rides the stock to the downside. To do this the investor or trader sells the stock in question while not actually owning it, e.g., being “short” the stock, and pockets the proceeds of the sale with the idea of buying the stock back later at a lower price as the downtrend takes hold and extends to the downside. To go short, the seller must first borrow the stock from her broker and may have to pay a very small fee to do so. If and when the stock drops in price, the seller then repurchases the shares, “covering” her short position, for less than she sold them, returning the borrowed securities and pocketing the difference. This is, of course not a risk-free proposition, as the short-seller may also end up owing the difference if the stock rises in price and the cost of buying back those shares exceeds the proceeds they pocketed at the time of the initial short-sale. Because stocks can theoretically rise to infinity while their decline is finite given that a stock price cannot go below zero, or 100% of its current value, then the potential losses a short-seller faces are unlimited. Of course, this assumes that a short-seller is operating without a stop-loss that provides a clear point at which the short-sale would be covered and the trade closed out at a loss, hopefully a small one.
To some, short-selling represents the “dark side” of the market, and history has often characterized the art of selling short as an evil enterprise, embodying a conspiratorial or pessimistic frame of mind that fixates on the negative. Consider that during the Great Crash of 1929, Jesse Livermore made $100 million in 1929 dollars, an astronomical sum at that time, by short-selling stocks during this severe market downturn. When this was later disclosed to the public, Livermore was the subject of extreme public outrage, even to the point where his short-selling activities were blamed as part of the cause of the great crash. In reality, Livermore merely observed and acted upon the market facts as they became apparent. The true cause of the Crash of 1929 was the fact that everyone had piled into the market and there was nobody left to buy stocks at that point. As well, paltry 10% margin requirements allowed investors to buy $100 worth of stock with only $10 in their pocket, creating a massive asset bubble and the optimal conditions for a rapid and destructive popping of that bubble.
Thus, stocks find their value given the circumstances, and short sellers can act as a catalyst to help stocks reach their true value faster than they might without any short sellers. Supply-demand mechanics have shown time and time again that even when short sellers pile onto stocks as they did the dotcoms such as Amazon.com (AMZN) in the early 2000’s, their short selling has no long-term effect on depressing price if the perceived value of the stock continues to be higher than where the stock is currently trading.
Short-selling is therefore part of the “corrective” process whereby excesses in the stock market as a result of speculative fevers are cleaned out. In the same manner that wildfires help to clear out overgrowth in the forest, the correcting and clearing out of prior speculative excesses in the stock market allows for a new, healthier growth phase to take hold. This is the essence of the stock market as a price discovery mechanism, and short-selling is part and parcel of that mechanism.
In today’s market, short-selling has been a tough road as markets have barely corrected so far in 2017 at the time of this writing (7-27-17) though today's action may lead to further weakness. Singularly, using the above analogy, much forest overgrowth that has been sprayed by fire retardant quantitative easing (QE) thus the overgrowth is arguably at all-time highs as markets have been unable to stage any meaningful correction since QE took hold in early 2009. And at present, the flow of QE is also at all-time highs which explains why the US market has corrected only a paltry few percent so far this year, an unprecedented occurrence since it began in its present form in 1957.
With QE remaining at all-time highs and Trump's economically favorable tax policies waiting in the wings, markets are so far unable to stage any sort of meaningful correction. Nevertheless, as today's action showed once again, leading stocks will get hit hard on days such as yesterday. One can then watch for possible reentry points using various buying strategies such as Wyckoff undercut & rally which we describe in our VOSI Voodoo reports HERE.