Lots of people seem interested in betting against stocks here. My email is filled with negative people saying that the market has to come back down and they want to profit from the coming decline.
I don't see it that way. I want to buy any decline because I think that much of the selling we saw, including the panic selling, was from professionals and the professionals have been routed and are now done selling.
But let's say you want to bet against a stock. Last time I talked about how to do this, on
, the next thing you know I was investigated by the government for being short a stock and bashing it. The whole thing was amazing to me because it was totally untrue. (I won't mention the stock's name because it will just start the whole shooting match up again, but I will point out that it has dropped 85% since I said it was too high.)
So, this time, I will use
National Gift Wrap & Box Company
as an example, so that it is perfectly clear that I am not picking on any particular company.
Let's say you see National Gift rally big for no particular reason. That in itself is absolutely
a reason to short a stock. Valuation is not a reason to short a stock. That's how you get put out of business. The other day someone emailed me about a biotech stock she was shorting simply because it had gone up! Of course the stock romped another 10 points and she wound up begging someone to take the pain away.
Now, let's say National Gift Wrap rallied 10 points because it announced that it was going to spin out
, an online business-to-business wholesaler of gift wrap.
You think this whole B2B thing is totally dead and that the stock should not have rallied at all. You have decided that you think it can go back down 10 points when the hoopla dies down. So you want to short it. What is the first thing you should do?
You should pick up the phone and ask your broker if you can borrow the stock, because when you sell a stock short you still have to deliver the shares to the buyer, as if you actually owned them.
Every short we put on starts with this process, which is called a "locate." If we can't get a borrow on the stock, meaning that every share is already lent out to other short-sellers, that ends the process. So if we call and we get a "no good" on the stock, that means we are not able to provide stock to the buyer -- so we can't short it. Some firms might do that; it is illegal, so we don't.
We could then buy puts on the stock if we were so inclined. You can buy up to about 100 puts (a short of 10,000 shares) without getting "help" or asking the broker to "put you up" on the puts. In the world of institutional money management you need to find the other side of the trade, so to speak. That is, you need someone to facilitate the trade for you. You can't just slap the puts on because
nobody is just out there willing to sell you a ton of puts
unless you are in a very liquid name. And National Gift isn't one of those.
That's why we would not bother buying a large amount of puts even if we thought it made sense to go lower. We figure others are already doing that. Because of the peculiar nature of short-selling -- where you have to buy the stock back either, a) in order to make a profit or, b) because the brokerage house can't find any stock to borrow -- we don't traffic in these heavily shorted names. The odds are too great that we will have to cover violently and at an awkward time because there are so many others doing the same thing. We call these gang-tackle shorts and we try to avoid them all of the time.
Now let me give you the real secret of why shorting is so dangerous and should only be done by the greatest risk-takers. Let's say National Gift goes up 10 points and I want to short it. I call
, my broker, and I ask for a locate on 10,000 shares. The word comes back that the locate is good.
I then sell short 10,000 shares.
Two weeks later the stock goes up another 10 points and I get a call from my broker. They need my shares. I say, "Hey, that's cool, I got a locate when I did the trade, so just check with stock loan. They will give you the stock that I located and borrowed just for this purpose." "Oops," they say, "that locate is no good anymore."
Incredibly enough, you are out of luck. Locates gets cancelled all of the time. So, the broker makes you "buy in" the stock you sold so you can deliver. Not only are you going to take a big loss, you could make it even bigger by piling on and buying in what might be a short-selling frenzy.
What a nightmare.
Sure, puts allow you to avoid the buy-in. But if the stock you are buying puts on is heavily shorted, you might just lose all of your money anyway.
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