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January 1, 2003

Shorting The Market: Short selling strategies are booming for traders,but a stigma persists.

By Nina Mehta

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  • Shorting The Market: Short selling strategies are booming for traders,but a stigma persists.

It's a great time for bears and the favorite strategy of those who think the sky is falling.

That strategy, of course, is short selling, which is achieving near record popularity as investors look for ways to escape a brutal S&P 500. That has been dropping at an annual rate of 20 percent. So it should come as no surprise that shares shorted on the Big Board and the Nasdaq have been at near record numbers.

This aggressive gamble on a declining price, which calls for a stock to be borrowed, has been a tremendously effective strategy over the last few years. Indeed, the average short selling fund was up about 30 percent through most of last year.

How did bears get so much honey? The profit is the difference between the price at the time the stock is shorted and when it is covered, or repurchased. And it is this strategy that traders say has fuelled some periodic rallies in the market. Because of the high risk, most shorts are arbitrage-driven.

Attracting Money

Still, there is debate about shorting. Is it starting to appeal to the average investor or is this extreme strategy just attracting more money? Market observers disagree on this point. But one trend over the past few years is that short interest in stocks has risen fairly dramatically. That's according to Mike Schurmann, a senior analyst at the Leuthold Group, a Minneapolis investment manager that has various short selling accounts for pension and trust funds. In part this rise in short interest means that the knives are out for more stocks. Nonetheless, it doesn't make short selling a safer proposition, even with a stock that has many short sellers.

"With high short interest, you can have a double momentum of the stock price moving in a positive manner based on its own fundamentals and then, on the trading side, because short sellers need to get out of positions," said Schurmann. "And it snowballs." Recently this has tended to occur in the telecom, wireless telecom and airline sectors-industries that make big negative news. That kind of news attracts short sellers.

For an investor who wants to put on a short, one of the keys is actually finding the shares to borrow. A long/short hedge fund manager in New York, who did not want to be named, points out that it's almost never difficult to borrow a stock to short, unless it's United Air Lines (NYSE: UAL) or another stock in similarly dire financial straits. UAL stock, he says, couldn't be borrowed for the last year.

There are now online stock-lending platforms such as EquiLend and the smaller SecFinEx. But for most short sellers the best solution is having a good prime broker or two. The most effective brokers have a large stock of securities or solid connections that enable them to call around and locate the securities sought.