Chuck McDannald: “What are the implications of shorting a stock (currently $6/share) that is likely headed for bankruptcy? If it goes all the way to zero, I guess I get the whole $6, is that right? Or what if the company files for bankruptcy protection at some point on the way down? If I ‘know’ they are bankruptcy bound, everyone else does too, so would there even be any shares to short?”

Well, the first thing to say is: shorting stocks is dangerous! “Likely to go bankrupt” isn’t the same as going bankrupt — and if something unexpected happens, this stock (whatever it is) could really jump. Why? Because everyone knows it’s a dog and the price, presumably, reflects that. The only people buying it may be very, very stupid people. But usually — not always — there are as many very, very stupid people selling, so they cancel each other out.

Indeed, some very, very smart people may actually be buying this dog at $6 along with the very, very stupid people. Very, very smart people may on occasion see, or know, something that the rest of us — who are neither brilliant nor Brillo but to whom it’s obvious this stock is headed to zero — may not.

So, point one: who knows.

The next thing to say is that bankruptcy is often not the end of the game. If memory serves (sometimes it does, sometimes it doesn’t), a rotten little clothing retailer called the Gap went bankrupt a long time ago. But it emerged from bankruptcy — the stock never went to zero but got real close in 1988 — and today has a $30 billion market value.

Or look at that rotten Apple that seemed pretty well headed for oblivion. Or at Chrysler that was once a total goner.

So whatever dog you have in mind will PROBABLY go down, which is why people are selling it; but it just might surprise you, which MAY be why some people are buying it.

Now that we have that part settled, here’s the other part. If you short it, you don’t WANT it to go to zero. If it does, you have to realize the short-term capital gain. (Gains on short sales are “short-term” even if you held the short for 100 years, because you sold the stock less than a year and a day after you bought it. In fact, you sold the stock, in this example, 100 years BEFORE you bought it.) So you might well see 30% or 40% of your profit taxed away. Heads you win 60% of your profit after tax, tails you lose close to 100% of your loss. Tough game.

No, what you’d prefer to see is the stock languish for around $1 for years, as it bungles in and out of bankruptcy. That way, no tax is due.

If you want to take a flier betting against this stock, you might be able to buy puts, so at least your risk would be limited to 100% of the cost of the put. But the problem with that is that the seller of the put is no idiot either, ordinarily, so it will cost you a pretty penny . . . and the stock might well hang on around 5 or 6 until long after your put expired worthless.

You can make a lot of many betting on the short side, but very few people do, and the risks are enormous.

 

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