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Money Making in Down Markets

[By Julia O’Neal; MA, CPA]

When a physician-investor buys a stock, he or she is said to be “long” the stock. “Shorting” is selling a stock a physician-investor does not own. 

Investing or Betting? 

Like buying a “put”, short selling is a bet that the stock will go down in price. The short seller sells a security he or she does not own, in anticipation of the price falling, and borrows the security to deliver to the buyer.  

Covering-Up 

When the short seller has to “cover” the borrowed stock, he or she will have to buy it. The short seller hopes to buy back the stock at a lower price to repay the loaned stock. If it must be bought back at a higher price, the short seller loses money. 

Unlimited Loss Potential 

Because there is no limit on how high the stock could go if the short seller is wrong, there is no limit on how much could be lost. (The physician-investor who is “long” a stock can lose only the entire cost of the stock.) 

“Shorting Against the Box” 

A physician-investor may sell a stock short simply because he or she believes it is going down, but may also “sell short against the box” to protect a long position.  This is a strategy used particularly when income tax rates for long-term capital gains are lower than ordinary income or short-term capital gains.  

For tax reasons, the physician-investor does not want to sell some stock that is owned.  

However, he or she believes the stock is going down and wants to be protected. The physician-investor will profit from a short-term decline in value, but can still hold the security for a possible long-term gain.  

The Short-Sale rule 

Short sales can be made only after a plus tick (ticks are movements of 1/8 or more for listed stocks and can be increments as small as 1/64 for NASDAQ or OTC stocks) or a zero plus tick.  

That means short sales can be made only after the stock has sold for either a higher price or the same price, but the last price difference was up. Ironically, the short interest theory holds that large short positions are bullish for a stock.   

Assessment 

Even though many physician-investors are obviously anticipating that the price will fall, the buying pressure (“short squeeze”) engendered by all of their need to buy the stock to cover their borrowing is expected to raise the price of the stock. 

Conclusion

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