When people think a stock is headed down and want to profit from that, they sometimes “go short.” That is, they sell shares they don’t own (they borrow them) and hope to buy them back cheaper (to return them). A sweet deal when it works. Borrow 1000 shares of a stock and sell them for $30 a share — $30,000. Then watch it fall to $18 and buy it back for $18,000 to return it. Bang: a $12,000 profit, less commissions and taxes.

The problem comes if the stock rises. You may be forced to “cover” your short — buy back shares and return the stock — even if you don’t want to. Say the stock jumps to 50 and you are sitting with a $20,000 loss. You may have to quit while you’re behind, even though you’re all but certain the stock is now even more wildly overpriced and will eventually plunge.

Why would you have to cover?

For one of five reasons:

First, you may find yourself completely unable to sleep or concentrate on your work with this nightmare hanging over your head. (What if the stock hit 100 or 200 and you lost your life’s savings?) For the sake of your sanity, you are squeezed into buying in the borrowed shares to close your position. (And your buying itself pushes the stock a little higher, adding to the woes of others who, like you, have sold the stock short.)

Second, you may find that, while you are comfortable riding out the insanity, confident that this tree will not grow to the sky, your spouse does not share your view — and is making your life intolerable. For the sake of your sanity, you are squeezed into buying in the borrowed shares to close your position. (And your buying itself pushes the stock a little higher, adding to the woes of others who, like you, have sold the stock short.)

Third, your broker may call and inform you that you have no choice: without an immediate infusion of fresh cash, you do not have enough assets in your account to support this short position, and it will be at least partially closed out whether you like it or not. (And your buying itself pushes the stock a little higher, adding to the woes of others who, like you, have sold the stock short.)

Fourth, some crafty folks who are long the stock may try to increase your pain by instructing their brokers to move their shares from their margin accounts to their cash accounts. When they do that, their broker can no longer lend their stock to shortsellers. And if you happen to be the shortseller who borrowed those particular shares, your broker may not be able to find new borrowable shares to replace them with. So he may call and tell you that you have been forced to buy the shares to return them to their rightful owners. (And your buying itself pushes the stock a little higher, adding to the woes of others who, like you, have sold the stock short.)

Finally, the first four reasons may have squeezed so many other shortsellers into buying stock to cover their shorts that now the stock is $95 and you are not $20,000 in the hole but $65,000, and suddenly reasons one or two or three, which had not applied to you before, now do.

Eric Jones: “I know you prefer that people invest in stocks for the long term, but what about making a quick buck on special situations? Recently, Rambus (RMBS) went from $80 to $450 in a couple of weeks based upon a positive announcement and a lot of short covering. I’m sure that there are more stocks with a large short interest that are poised to shoot up on any good news. Would this be a strategy worth pursuing on a regular basis or at least once in a while? For example, 4 Kids Entertainment (KIDE), has a float of 5.2 million shares and 5.3 million shares shorted. The company has no debt. The company holds the world-wide licensing rights to Pokemon outside of Asia plus other licensing rights. If the Pokemon “fad” isn’t over yet, on any good news this stock seems ready to repeat the big run up in price it saw last year.”

To which I responded: “You could luck out, Eric, but this isn’t investing, it’s game theory — and if you did win, you would share a large chunk of your good luck with Uncle Sam (while laying off only a small share of your losses).”

To which Eric responded, with a malicious grin: “Sorta like shorting AMZN.”

Touché. Except that, really, I see a big difference.

With the short squeeze plan, you’re hoping something that’s already overvalued will become even more so. You’re hoping for (and, by buying, adding to) very wacky behavior, which ultimately does the economy no good. With a short sale of the type I occasionally make, you’re leaning against the tide of irrationality (or at least you think you are), not adding to it. I’m not suggesting you should be sainted for doing so. But rational valuation is an economic plus, where irrational valuation is a minus.

Not to make a big thing out of Eric’s light-hearted comment, but as you can see, it got me thinking. Always a dangerous thing.

 

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