In the last installment of The Finance Professor, I explained the mechanics and operational aspects of short selling. Now I want to address short selling from a trading and investment perspective.

There are several factors that will motivate a trader or investor to short sell a security . Here are the three main strategies and the reasoning behind them.

1. The Valuation Short

I discussed the concept of fundamental stock trading in an earlier lesson. To review, fundamental research on a company will typically result in earnings estimates which then translate into a price target . When this is accomplished we can then compare our price target to the current stock price . If the stock is below its price target then we will usually be inclined to buy the stock. However, if the stock is above its price target we might avoid or sell the stock, if we owned it. In some instances, the price target is significantly lower than our price target and the short sale of that security might be in order. For example, say that you value a stock at $40 and it is currently selling at $50. According to your analysis, selling short the stock at $50 will yield a $10 profit if the stock hits your lower price target.

Why would you institute a valuation short? There are two potential reasons. First, you may come to the conclusion that current earnings estimates are inflated and the stock is priced on improper assumptions. Second, earnings growth may be slowing, which will result in price-to-earnings multiple compression. As a current example of this, I have recently sold Starbucks ( SBUX) short in anticipation of declining earnings and growth rates .

Valuation shorts are very dangerous because expensive stocks can become more expensive. This strategy should not be used recklessly. Take for example Amazon.com ( AMZN), a heavily shorted stock. The company may appear to be too expensive because it trades at 100 times its current earnings, but that has not deterred investors from ramping the stock even higher. Remember, as economist John Maynard Keynes said, "The market can stay irrational longer than you can stay solvent."

2. The Event-Driven Short

Whether on a macro-market level or on an individual company basis, there are distinct events that can provide trading opportunities to the short seller. Event-driven trades rely on a specific isolated occurrence, after which a profit is made or lost, but in either case, there is a clear finality to the trade. Here are a few types of events worth noting:

  • Earnings Announcements: In anticipation of an earnings announcement, short sellers will seek to position themselves in favor of an earnings disappointment or guidance reduction (see "Beginner's Guide to Earnings Calls" or "Five Missteps to Avoid in Earning Season" ).
  • Court Cases: There are matters of judicial decisions that can impact a company or several companies. My most successful short (and one from which I gained notoriety) was that on Martha Stewart Living Omnimedia (MSO). My thesis was that not only was Ms. Stewart going to be found guilty and sent to jail but her eponymous publishing and media business would suffer as a result.

    Another example: Research In Motion (RIMM) was engaged in a civil matter over patent rights with NTP , a privately held corporation. Early in the litigation, Research In Motion was an excellent short as it continued to lose court battles. However, once Research In Motion and NTP settled, Research In Motion made an excellent long . I have played Research In Motion both ways -- long and short -- with much success.
  • Economic Data Releases: Macro-market shorts are often made in anticipation of an economic data release or data-related event, such as the monthly non-farm payroll survey, FOMC interest rate announcements or GDP data (see "Five Things You Must Know About the Fed" ).

As you can see, events can be used not only for short sellers but for long-side traders as well. However, the construct for a short based on an event is necessary for any discussion of short selling.

3. The Arbitrage Short

Arbitrage transactions are the simultaneous purchase of one (or more) securities and the short selling of one (or more) other securities, which may or not be related to each other. Some common arbitrage transactions are:

  • Index Arbitrage: This is the off-setting of a "basket" of stocks vs. a derivative , such as index options , futures or swaps .
  • Convertible Arbitrage: Typically achieved by buying a convertible bond or preferred stock and then short selling common stock or options (on a delta basis) against the convertible securities.
  • Risk Arbitrage: Risk arbitrage opportunities exist when one company has agreed to or is in the process of trying to acquire another company. Since the deal has yet to be consummated, there will be a risk that the deal will fail, thus creating a discount to the price of the target shares . In that situation, the arbitrageur will buy the target company and short sell the acquiring company. For example, Toronto-Dominion Bank (TD) has recently agreed to purchase Commerce Bancorp (CBH) for 0.4142 TD shares plus $10.50 for each CBH share . The arbitrage here would be to buy CBH and short sell 0.4142 TD for each CBH share.
  • Pairs Trading: When the relative values or technical nature of two stocks have diverged this may create a trading opportunity. Some traders will refer to this as "mean reversion trading." What follows is an example of pairs trading. Below is a two-year chart of Abercrombie & Fitch (ANF) (in blue) vs. American Eagle Outfitters (AEO) (in red). The assumption is that the two stocks are closely related in terms of fundamentals and business models, so they should perform relatively in synch with each other. However, as we see in August 2006, ANF was cheap relative to AEO. At that time, an investor would probably buy ANF and short sell AEO in anticipation of ANF rising relative to AEO over time. And that is indeed what happened over the course of the next year until finally, the spread between the two stocks' performance collapsed by August 2007.

  • Short Against the Box: This was a frequently used strategy that took advantage of an old "loophole" in the tax code that has since closed. Under the old tax code, if you owned a low cost-basis stock, you could sell the same company's stock but instead of selling your long stock you set up a separate short sale. This created a separate long and short in your account , thus avoiding the realization of a capital gain . You can still use the "short against the box" strategy for short periods of time so long as you comply with the related Internal Revenue Service (IRS) regulations. As an alternative, many investors now create a pair arbitrage to attempt to replicate a short against the box. However, the pair is not as precise in off-setting risk as is the short against the box.

While it may seem that we are finished discussing short selling, there is one final lesson to be learned. Next time, I will cover the risks of short selling. Until then, here is some homework:

1. Look for a fundamental short opportunity, based on your analysis of a company.

2. Look ahead to a data-related event and strategize how you would position yourself leading up to the event and how you would trade after the event has occurred.

3. Try to create a pairs trade like the one I highlighted above.
At the time of publication, Rothbort was long RIMM and short AMZN, 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.