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TheStreet Open House

Knowing the Rules of the Shorting Game

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Click here for the latest filings from James J. Cramer.
Many of you have communicated to me that you would like to know more about shorting. I usually toss shorting off as "the mirror image" of going long. When you go long -- remember that is the term we use, not "buy" -- you are buying with the idea that a stock will go up.

When you buy, you take it for granted that the stock you buy will be delivered to you. When you sell the stock, you get the difference between the price you paid and the price you sold it at. Your stock is returned automatically to the buyer.

Smarter Money: Join the discussion on TSC Message Boards . Short-selling works the same way. You sell the stock. You buy it back, or "cover," and you get the difference. If it went higher, you lose; if it went lower, you made money.

There is one giant difference, however. When you buy a stock, you know it is going to be delivered to your account. When you sell it short, you don't own the stock, so there is no surety to the process.

You have to be able to borrow the stock first to be able to short it. You have to find out from your broker if the stock can be borrowed first.

That's a difficult process sometimes. First the stock you want to sell short must be located. A whole department in a brokerage house, the "Locate" department, tries to find the stock. Sometimes it is impossible to find because there are no shares around to borrow. This "hard-to-borrow" status occurs when stocks that have a very small float get ganged up on by a group of short-sellers.

Why else does a stock get hard to borrow? Often the owners of stock don't allow their stock to be used by short-sellers. They take their stock out of the borrowing box that each investment firm has. So for example, let's say you own National Gift Wrap.com and you are convinced the fundamentals are strong. But you think the shorts are leaning all over your stock, pressing it down.

You may be unwittingly aiding the shorts by allowing your National Gift Wrap.com shares to be let out to short-sellers. It will be lent out if you say nothing because you signed a "hypothecation" agreement when you opened your account, allowing them to lend it out. That's one of the great secrets of Wall Street. It happens automatically unless you say something.

If you take National Gift Wrap out of Street name, or request that it can't be borrowed by short-sellers, the brokers have to obey your wishes. Are you an unwitting abettor of the bears on National Gift? Ask yourself that question with any stock you are long.

When stocks get hard to borrow, sometimes the short-seller has to pay, literally pay cash, to find the stock he needs to stay short. He pays it as a percentage of the dollar amount that he sells short. People right now are paying as high as 15% of the proceeds to stay short on hard-to-borrow names.

What happens if you short a stock and the stock can't be borrowed? In other words, more stock is shorted than can be found because so much has been taken out of Street name and so little floats to begin with?

Ahh, now that's the biggest question. I have had it happen to me several times and it is quite frightening even for professionals. First, you get warned by your custody broker that you are "failing to deliver" stock. You complain, if you shorted legitimately, that you got a locate first. Your custody broker then tells you another Wall Street secret: It doesn't matter. If you have a locate and the stock has, in the interim, become hard to borrow, you are just plain out of luck. You have to scramble to find stock all over again, and if the broker can't find it, you probably won't be able to find it either.

The custody broker will then threaten to "buy in" your stock. These are the two most dangerous words in the lexicon of the short-seller. That means the broker will simply go into the open market and buy your stock back wherever he wants.

So, you are short National Gift. You have a borrow. The stock is at 15. It rallies to 23. You get a call from the custody broker saying that he can't find any stock anywhere and that he needs you to deliver stock to keep your short.

You then say, "Not fair, I got a locate. I already used the stock you lent me."

Stock loan says, "Sorry, the situation has changed. If more stock doesn't come in for sale from natural long-sellers, we are going to have to buy you in."

One tactic that the shorts then do is to offer even more stock, even though it is short, particularly before the opening, to "make the stock look heavy." That's the actual term for this travesty. Short-sellers need to beleaguer longs into selling. It's a common tactic and one that usually works.

Long-sellers materialize and the delivery gets completed. That's short-selling tactics at its nastiest but, some would say, at its best.

But if it doesn't bring out sellers, then the "buy-in" process starts.

Here is another great mystery of Wall Street. What happens in a buy-in is that the stock loan department executes an order in your behalf to buy the stock back. You don't even know it! You find out the next day that you bought stock that is then used to complete somebody else's sale.

It is done, sometimes at market prices, sometimes above market prices, usually in the last hours of the day when it is clear that no new stock has come in. It is devastating to the short and moves the stock up smartly.

I know that this whole process seems unfair to the short-sellers, but nobody ever said that long-sellers and short-sellers were created equal. The reason why my firm does very little shorting is because the mechanics are so hard. This buy-in process tends to stack the deck against the short-seller.

It can be very frightening to study your run the next morning and see that you bought National Gift without your knowledge. But that's the way of the world.

That's why I keep stressing that you need to know how much of a stock's float is short before you short aggressively.

If I know that National Gift is heavily shorted, I am careful not to jump in and complicate the situation. Even if I believe the stock is headed lower, I could be wrong precisely because a stock is hard to borrow.

So if you are going to get in this game, know the rules, and know that the rules change when a stock gets "tight," or hard to borrow, tipping the balance in favor of the longs against the shorts.

It happens every day.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at jjcletters@thestreet.com.

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