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June 30, 2003

Short Sellers on The Road to Ruin? Poor Timing, Some Stumble in the Market Rally

By Tom Taulli

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  • Short Sellers on The Road to Ruin? Poor Timing, Some Stumble in the Market Rally

Short selling, a practice perpetually steeped in controversy, always gets bad press, especially when markets are heading south in a hurry. And even when markets are rising, short sellers, critics say, appear to be doomsters wishing for train wrecks.

"As prices surged, they kept adding to their positions, which made things worse," said Rob Grapin, a managing director of New York-based Carlin Equities, which provides electronic trading services to hedge funds.

Grapin was referring to the recent rally, which caught some shortsellers offguard. Yet short selling is a vital strategy that some traders rely on to give their clients a chance to obtain good returns in bear markets. But if critics of the practice want solace it is this: Short selling is a dicey, often expensive, strategy that can frustrate the trader and even blow up.

Just financing it can be difficult, according to David Saunders, a managing director at K2 Advisors, L.L.C., a hedge fund of funds firm based in Stamford, Conn. The cost of "the borrow" is steadily creeping up, he says.

"For some hard-to-borrow securities," Saunders told Traders Magazine, "the cost could reach 30 percent [of the market value of the position]on an annual basis. However, the hedge fund guys are not looking at the cost of borrowing. These costs can add up and cut into the returns of a fund."

Perhaps one of the reasons for the higher costs is the growth in hedge funds, which are active short sellers. "Do you want to be shorting heavily borrowed stock?" asked Saunders, himself a former trader for the legendary Michael Steinhardt.

"There is anecdotal evidence that heavily shorted stocks can have much higher betas in market rallies," he added. Saunders refers to this as beta inflation; that is, if markets increase 10 percent, a heavily shorted stock could increase several multiples above this.

Saunders recommends risk controls for firms that short. "I look at two parts," he said. "First, you want the overall portfolio of short positions to be diversified. Second, you want to have a strong risk discipline."

Short selling involves a web of relationships. When an investor sets up a margin account, he agrees to allow his broker to hypothecate his shares. This is a fancy legal way of saying that your broker can lend your shares to short sellers. For most heavily traded stock, it is not difficult for a broker to find shares to borrow. But, if the company is small and illiquid, it could be literally impossible.

Or, the stock may already have significant short positions and there are no other shares to borrow. So, an investor may have spent a lot of time studying a chart of several companies and put in a short sale order - only to learn that there are no shares to borrow.

The rule: The investor should ask his broker first about whether the shares can be borrowed (and how much).

Some other strategies suggested by trading experts:

* Set up accounts with different brokers. Some brokers have better access to some stocks than to others.