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Three Risks Every Short-Seller Must Know

10/18/07 - 11:55 AM EDT

Scott Rothbort

A popular class of hedge fund hedge-fund is one which is referred to as the "long-short fund." Long-short funds employ a strategy of purchasing a portfolio portfolio of stocks and then hedging those stocks with a portfolio of short sales. A pure long-short fund will be equal dollar long vs. equal dollar short (or 100/100). The long stocks are purchased for cash and will then be utilized at 50% margin value to collateralize the short positions short-position. A variation of this theme was the "130/30," where the strategy was to be net long long-position but to leverage leverage up the long position by 30% and hedge with 30% of short sales, which were collateralized by the net marginable value of the long stocks.

Here is the problem with these strategies: If you sustain large losses on one side of the trade, then you will no longer have enough equity equity in the account to satisfy the margin requirement for the combined strategies. These long-short hedge funds racked up tremendous losses this past summer of volatility volatility and were forced to liquidate liquidity in order to meet margin requirements. This was a result of either the shorts losing money while the longs were underperforming or both the longs and the shorts were losing money.

How can you hedge this potential loss of capital? The same basic rules of risk management apply for leverage for on the short side of the market as they do on the long side. Over reliance on leverage can result in rapid deterioration of one's capital. So the best advice here is to use margin and leverage sparingly and wisely (see "Understanding Leverage").

3. Borrowing Risk

By now, we know that obtaining a stock borrow is critical to achieving a short sale. One of the biggest risks to a short-seller is the loss of that stock borrow.

If the supply of stock available to borrow dries up, then short-sellers might be required to "cover" their shorts or be subject to automatic "buy-ins" by the stock lender and selling broker (see "How Short Selling Works"). Systemic rapid short-covering is referred to as a "short squeeze." Short squeezes occur when shorts are forced to cover because of industrywide loss of available stock to borrow or when a bullish event causes a cascade of short-covering.

To see an example of a short squeeze that is currently occurring in the market, observe Amazon.com AMZN. Amazon.com stock is selling at nosebleed valuations valuation because the momentum momentum-investing traders keep pushing the stock higher, while the shorts are faced with high levels of short interest short interestand "days to cover."

As a short-seller, before you enter into a short position, there are several metrics which you should be familiar with and must incorporate into your trading analysis. The following is a breakdown of those metrics.

At the time of publication, Rothbort was had no positions, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.


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