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Ask The Trader
Monday, August 21, 2000

Some Basics on Shorting


You've spent some time defining trading terminology. I would appreciate it if you would please define the purpose of "shorting", adv. and disadvantages. Thanks very much for excellent insight in the stock market.

Harvey

To answer this question, let us first go through the process of shorting a stock and then we'll explain its risks and rewards.

When a trader is looking to short a stock, he or she is anticipating that the price of that stock will decline. To profit from the fall, the trader will try to sell high and buy back shares at a lower price, the difference being a profit. For example, let's say a trader is expecting shares of AMZN to fall, so he or she sells short 100 AMZN at $50. The brokerage firm will lend the trader 100 shares of AMZN, using either its own inventory, shares in the margin account of another customer, or shares borrowed from another broker. The trader now holds a short position in AMZN, which means that he does not own the 100 shares of AMZN and must repay the shares to the lending broker at some point in time. While holding this short position, if the shares of AMZN drop to $40, the trader can buy back the shares for $4,000. This would close the short position and produce a profit of $1,000, or $10 a share.

One of the main advantages of shorting is that it allows a trader the versatility to profit from bearish market conditions and makes trading a two-dimensional game. With this added flexibility, the number of potential opportunities increases tremendously. However, with each new opportunity, the potential for loss increases as well.

The biggest risk of shorting stock is the unlimited potential for loss. To illustrate this, let's compare the loss potential of a long position to that of a short position. A 100-share purchase of stock at $10 can risk a maximum loss of $1000. However, a 100 share short sell at $10 will risk more than the $1000, when the stock advances above $20. Additionally, it's important to consider that brokerage firms charge interest for borrowed shares, which is usually comparable to margin rates.

Ok, now on to this weeks charts.


ERICY has been stuck around 19 since it split 4:1 back in May. What is your opinion of this company and what will it take for it to break out past resistance? Thanks - Gary

An interesting company you've found here. First, I just want to make mention that on several occasions I've seen 3:1 and 4:1 splits fall into a long consolidation range, after the split. ERICY seems to fall into this category. As for the chart, we've noted that stiff resistance is forming at current levels and could pose a good challenge to the current advance. With recent concerns about supply shortages in the cell phone equipment industry, one thing that may help ERICY regain its upside momentum, would be an announcement that they've overcome supply shortages and that demand remains strong. Strong revenues is a good indication of strong demand.


In looking at GE (General Electric), I was would like to chart out any thoughts you might have about its recent advance to a 52-week high. - thanks

Initial resistance looks like it will now come at the recent highs, as depicted on the chart. A break through this level on good volume, could be your signal new all time highs. It appears that GE has found some degree of support along its two recent highs near $56. Watch for news releases and general trends of the market to hint where GE plans to go next.


Good luck with your trades!
Mike Fairbourn
Research Analyst

 


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