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Benjamin Graham. The Wolf of Wall Street. Jordan Belfort. Steven Collings. When Genius Failed. Roger Lowenstein. The shorted stock is borrowed through a broker and sold in the open market with the proceeds from the sale placed in escrow. There are alternatives to selling short in the cash market. Selling futures has several advantages to selling short in the cash market.
Buying puts and selling calls are two ways to implement a short-selling strategy in the options market. There are trade-offs between buying puts, selling calls, and borrowing the stock in the cash market in order to sell short. The relative merits of using futures and options for short selling, along with a review of futures and options and their investment characteristics, are covered by Frank Fabozzi in Chapter 3.
In Chapter 4, Gary Gastineau describes how short selling exchangetraded funds ETFs can mitigate the risks associated with shorting individual stocks.
For example, it is essentially impossible to suffer a short squeeze in ETF shares because the number of shares in an ETF can be. Introduction 3 increased on any given trading day. On the NYSE exchange, this rule means that a short sale may only be done on an uptick or a zero-plus tick; that is, a price that is the same price as the last trade, but higher in price than the previous trade at a different price. On the NASDAQ, you cannot short on the bid side of the market when the current inside bid is lower than the previous inside bid a downtick.
A third advantage that Gastineau discusses relates to hedging with ETF shares instead of derivative contracts. Derivative contracts have limited lives. The most active contracts in any futures market are the near month and the next settlement after the near month. Equity index futures contracts will usually be rolled over about four times a year in longer-term risk management applications.
While risk managers could take futures positions with more distant settlements, liquidity is usually concentrated in the nearest contracts. Consequently, risk managers typically use the near or next contract and roll the position forward as it approaches expiration. In Chapter 5, Edward Miller points out that restrictions on short selling mean that prices are often set by the most optimistic investors, with little limited trading opportunities for the less optimistic investors, other than to sell there holdings.
The result is potential overpricing in some stocks. The opportunity to short sell such overpriced stocks is exploitable only when the overpricing is due to factors that are likely to be revealed in the relatively near future. Possible opportunities arise from optimistic errors such as extrapolating growth too far in the future, not allowing for new entry or market saturation, or just omitting low probability adverse events from expectations.
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Miller builds on these points in Chapter 6 by arguing that a substantial divergence of investor opinion about a stock implies a negative expected return. Miller further demonstrates that because risk correlates with divergence of opinion, the return to risk, both systematic and nonsystematic, is less than what investors would otherwise require.
This leads Miller to suggest that typical investors should overweight the less risky stocks in their portfolio. Owen Lamont provides evidence of overpricing by showing that stocks with high short sale constraints tend to experience particularly low returns in the future in Chapter 7. Steven Jones and Glen Larsen illustrate, in Chapter 8, how short selling has the potential to improve upon the mean-variance return performance of portfolios.
Jones and Larsen point out, however, that this empirical research focuses on risk reduction and ignores the potential for identifying overpriced stocks. They also emphasize that short positions must be actively managed due the risk of recall and the transitory nature of overpricing. In Chapter 9, Jones and Larsen provide an overview and analysis of nearly all of the academic research, from the past 25 years, on the information content of short sales.
However, the empirical evidence on whether short interest can be used to predict future returns is quite mixed, with much of the debate turning on the timing of the interval over which to measure the accumulation of short interest or future returns. Jones and Larsen conclude that there is ample evidence of overpricing in stocks that are costly to short, but short sales and short interest, while potentially useful, provide no easily discernible signal. The question remains as to whether there are any proven strategies for spotting short-sale candidates?
Three techniques are discussed in Section Three. Introduction 5 sales growth trajectory that their followers expect.
Firms may be able to trade off future performance for current results for a number of quarters to keep Wall Street happy. Just a couple of the accounting gimmicks they watch for are: 1 a heavy reliance on nonrecurring events and 2 businesses with high operating leverage that run factories full out while accumulating excess inventory. In Chapter 11, James Abate and James Grant show that while short selling based on poor or deteriorating fundamentals is a time-tested strategy, it has all too often been implemented using accounting earnings and relative valuation indicators.
They offer guidance on how to use net present value NPV and economic value added EVA as part of an active short selling strategy. In Chapter 12, Bruce Jacobs and Kenneth Levy describe how a marketneutral portfolio is constructed from long and short positions so as to incur virtually no systematic or market risk. Long—short portfolios free investors from the nonnegativity constraint imposed on long-only portfolios and relax the restrictions imposed by benchmark portfolio weights. Jacobs and Levy also suggest that active portfolio managers can achieve improved performance with an integrated optimization that considers both the long and short positions simultaneously.
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To a large extent, however, the performance of a market-neutral portfolio is determined by the value-added through security analysis and selection. The importance of short selling to the global equity market is investigated in Chapter 13 by Arturo Bris, William Goetzmann, and Ning Zhu. They collected information on short sales regulations and practices for about 80 markets around the world. These include several countries in Southeast Asia and South America.
This is to some extent because the issue of whether a security is easily shortable is an important one for many institutional investors and investment managers. He argues that divergence of opinion is correlated with both.
The marginal investors in stocks with high divergence of opinion are more likely to be overly optimistic. Reed, Ph. The equity lending market exists to match these short sellers with owners of the stock willing to lend their shares for a fee. The market is dominated by loans negotiated over the phone between borrowers and lenders. Self-regulatory organizations e. As described in Exhibit 2.