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Money Morning Members OnlyTHE ABSOLUTEBeginner ’sGUIDE to SHORT SELLINGHOW YOU CAN PROFITin ANY MARKET

Table of ContentsSection 1: The Other Side of the Trade . 1Section 2: 10 Rules for Success . 3Section 3: First You Borrow, Then You Sell . 7Section 4: Investing on Margin . 9Section 5: Margin Requirements . 12Section 6: What You Need to Know About Margin . 15Section 7: It Really Is This Easy . 18Appendix A: Keep These Things in Mind . 19Appendix B: Terms to Know . 20

Section 1:The Other Side of the TradeThe conventional approach to trading has us buying low and selling high.We set a goal, do our research, and then develop a conviction that a certain stock will go higher.And so we buy the shares, set our stops, hedge our position against a loss, and wait until the share pricestarts heading north. Then, if our hypothesis and our methods are sound, we collect a nice profit.That’s the rule. Millions of investors follow it. Simple enough But what the conventional approach doesn’t account for is that there are two sides to every trade.Share prices go up, to be sure, but they also go down.This is a simple truth, but it’s one that Wall Street would rather we not think about.Why? Because they take the other side all the time.And they make a killing when they do; quadruple-digit gains betting against huge companies likeT-Mobile, Best Buy, Ralph Lauren, even Apple.They even bet against entire countries; on one day in September, 1992, one man, George Soros, broughtthe entire United Kingdom to its knees and made 1.8 billion in profits betting against the pound sterling.It may have been the easiest money he ever made, and it was almost certainly the quickest.But if it became fully and widely understood that the huge Wall Street firms were betting against themarket why, that would undermine the public’s acceptance of the false narrative they’ve been spinningfeverishly since 1929 – that they are the sole, noble guardians of capitalism, that they are the builders ofdreams, that the wealth they generate for themselves is really for the good of all.There’s another truth to consider: You don’t have to be a Wall Street bank to trade like this.But you do have to be willing to set aside the bogus story that they’ve been selling for the 85 years.We can take the other side of the trade, too.Don’t worry – unlike Wall Street, we won’t be bringing the U.K. to its knees or destroying anything.We’re not James Bond villains; we’re investing for our futures.We’ll learn how and why to trade on declines, and how to protect our investments. We’ll learn fromexperts like Keith Fitz-Gerald and Shah Gilani, who have some excellent guidelines for these situations.And we’ll look at some examples of individual trades that paid off, even as share prices retreated.1

Section 1: The Other Side of the TradeNow that we’ve smashed Wall Street’s most potent illusion, let’s go and make some money.It’s easy How It WorksShorting a stock is Wall Street speak for betting that a stock will decline. An investor who is “short” astock only profits if the stock goes down.And don’t worry; the process is not as complex as you might think. In fact, it’s about as simple asflipping a switch.When you know an asset is going to fall, all you need do is take the other side of the trade.It really comes down to three easy steps:1. You identify that an asset that is obviously reversing direction 2. You take the other side of the trade 3. You haul your money to the bank!Here is what our Chief Investment Strategist, Keith Fitz-Gerald, had to say about the ‘flip-the-switch’strategy:“I’m actually a huge fan of short selling. It’s a really valuable strategic tool. It allows you to profit onweak companies as well as strong ones, in bad markets as well as good ones.”2

Section 2:10 Rules for SuccessKeith Fitz-Gerald’s Best Advice for Short SellingIn its most basic form, short selling is a bet on a company’s imminent failure and short-sellers searchfor stocks they believe are poised to fall.Typically, a short sale involves borrowing a troubled company’s shares from another investor, sellingthem, and then waiting for the stock’s price to decline before closing the position (“covering,” as it’scalled) by buying the shares back on the open market.The difference between the higher initial selling price and the lower repurchase price represents theshort seller’s profit.If this sounds confusing, don’t worry.After reading this report, you will realize how simple it really is. All you need is an intuitive sense ofthe short selling process and knowledge of some key terms.The rest is really your broker’s job. After all, you do pay them a commission.Before we get to technical, it would be wise to consider Keith Fitz-Gerald’s 10 most important rules ofshort selling.You will quickly notice that these rules are more like bits of wisdom that Keith has accumulated overthe decades he’s been in finance.Unfortunately, your broker is unlikely to share any of them with you directly, but we are.In fact, we believe that the 10 rules of short selling are invaluable to anyone thinking of taking theother side of the trade.Let’s get started.1. Timing is far more critical in short selling than when buying stocks.Timing really is critical when short selling, says Keith Fitz-Gerald, head of research at Money MapPress. Keith identifies short-sale candidates primarily from fundamentals, but waits to actually takeaction until signaled to do so by overall market action or specific technical indicators.A technical trigger is important because it may take some time for the market to recognizefundamental weakness in a company – and even longer to actually give up on the stock.2. Short selling is primarily a short-term strategy.Unlike on the “Buy” side, there are very few successful “sell-and-hold investors.” That’s due again to theinherent upside bias in the markets. Even when stock prices are locked into prolonged narrow tradingrange inflation can push prices up, creating losses for longer-term short positions.3

Section 2: 10 Rules for SuccessIn fact, the bulk of short selling in today’s markets is done by day traders and swing traders, all ofwhom wish to take small profits on the normal daily and weekly price fluctuations. Most long-termshort positions are taken by professionals, hedge funds, and savvy individual investors looking to offsetdownside risk exposure on large portfolios.3. Restrict most of your short selling to bear markets.This seems like an obvious rule, but it’s amazing how many traders violate it – and pay a painful price,as a result. Though it sometimes seems like we’ve been in one for a decade, true bear markets actuallycome along only about once every 3.6 years and historically last just under 18 months.The rest of the time, the markets are moving upward – and, since numerous studies have shown thatthe majority of stock gains (perhaps as much as 85%) result from overall market movements rather thaninternal company fundamentals, it makes little sense to buck the trend.Unless timing is perfect or you find a dying company a day ahead of everyone else, shorting into astrong bull market (or even in the waning days of a bear move) is like swimming against the tide – andit’s almost certain to thoroughly dampen your returns.4. When there is a bear market, short selling gives you a significant edge.Stock buyers and traditional buy-and-hold investors really have only two options when a bear marketstrikes (okay, three if you count hedging your holdings by purchasing “put” options).Investors can either endure the losses or try to ride out the downturn, or liquidate their stock positionsand move into cash or other assets. But if you understand short selling and are willing to use thetechnique, you can quickly exit your long stock positions – avoiding the bulk of the loss – and then sellthe same stocks (or worse ones) short, picking up new profits as the market continues to fall and otherinvestors cry over their losses.“My favorite entry point,” Keith explains, “is when we’ve had a huge up day in the market and the stockI’m watching has gone along for the ride, moving above its Bollinger bands, its Keltner channel or someother statistical measure of that stock’s normal trading range. That’s because, when I’m short selling, Iwant every possible advantage working in my favor – fundamental, technical and otherwise.”5. Being early is much riskier on the short side.If you buy a stock and have to wait awhile before it finally takes off, the upward bias of the overallmarket reduces your risk – in many cases costing you nothing but the time value of your money.4

Section 2: 10 Rules for SuccessThe opposite is true when you sell short.Not only does the upward bias of the market work against you, but there are also interest and margincosts associated with borrowing the stock you sell short. (You must have a margin account with yourbroker in order to sell short; short selling isn’t permitted in a regular cash account.)Even worse, it’s always possible for even the most overvalued stock to move higher in price. The dotcom bubble provided painful proof of that fact as many stocks in that sector achieved overvalued statusas early as 1998, but would have killed anyone who shorted them in 1999, since the bubble didn’t finallyburst until 2000. In short, never short a stock simply because you think it’s overpriced.6. Action on the short side is much quicker than action on the long side.Numerous market studies have shown that, on average, stock prices decline three times faster than theyrise. There’s also an old market maxim that says that bad news travels 10 times faster than good news.Both are based on innate human emotions – fear and panic being far more powerful forces than greedand exuberance. Thus, if your timing is good as a short seller, you can generally expect far quicker resultsthan you’d get on your long positions. Even so, always be aware that a crash or panic sell-off isn’t requiredfor a successful short trade.In many cases, a simple lack of news will be enough to quell buying interest and cause a price declinesufficient enough to produce a nice short-selling profit.7. The risk on short positions can be high – but contrary to the popularnotion, it’s not unlimited.Conservative advisors scare many clients away from short selling by claiming it has unlimited risk.“When you buy a stock,” they say, “all you can lose is the amount you paid because its price can’t go belowzero. But there’s no limit to how high a stock’s price can climb, and your short position will lose money allthe way!” This is actually false on two counts: You should never institute a short position without simultaneously entering a stop order to getyou out if prices move too far against you. (Your own goals and risk tolerances will help youdetermine where to put the stop, but we recommend an absolute loss limit of 25% on short sales.) Your broker won’t allow you to unwittingly lose more than your original margin deposit. If yourequity in the position drops too low, you’ll be asked to either cover your short or deposit morefunds. (Don’t!) If you do neither, the brokerage firm will liquidate your position to protect its ownassets, since it must cover unsecured client losses.5

Section 2: 10 Rules for Success8. If the stock you sell short pays a dividend while your position is open,you must pay the dividend to the broker you borrow the shares from.This is true – and it’s a major reason lots of people shy away from selling short. If you really know whatyou’re doing, however, this should never be an issue. After all, why would anyone in their right mindconsider shorting a growing company with solid earnings sufficient to allow payment of a decent dividend?On the other hand if a company cuts or eliminates a dividend, it might be a stock worth shorting,since such a move almost always indicates deeper problems at play.9. Not every stock can be shorted.As a rule, brokers will not allow you to short a stock priced below 5 a share (too much opportunityfor monkey business in the penny stock ranks), nor will you usually be able to short stocks that are verythinly traded or that have too small a float.In those two latter cases, it’s too difficult to find shares to borrow, and the lack of shares means volatilitywill be high, increasing risks.10. The “short squeeze” is a real risk – but it can be minimized.As noted earlier, overpriced companies – even those with terrible fundamentals – can sometimesdefy logic and move still higher. If they do so dramatically – perhaps even “gapping up” at the marketopen, traders who are short the stock may become fearful and put in panic “Buy” orders to cover theirpositions. This can push prices still higher, triggering protective stops, which can generate another gap,creating a new round of buying and perhaps even a self-generating uptrend – a classic “short squeeze.”If you get caught in such a squeeze, you’ll usually have to bail out – though there are two ways to avoidsuch situations: Don’t short stocks with “squeezable” characteristics, such as a high short-interest ratio, a smallfloat, a low daily trading volume, strong bullish sentiment or advisory support, a record of pastshort squeezes, or a still-intact uptrend. Maintain strict discipline. Always use a stop-loss order, adjust it regularly as the stock price movesin your favor – and, if you see any of the conditions listed above, either tighten the stop or goahead and take your profits.6

Section 3:First You Borrow, Then You SellThe Mechanics of a Short SaleWhen you sell a stock short, you profit only if the price the stock drops.Here is how it works.A short seller does not actually own the stock. He, or she, borrows the shares from a broker and thensells them to a third party.The borrowing part is a crucial element of short selling.Because the stock is borrowed, it needs to be returned. As such, it creates a liability that a short seller isresponsible for, much like a bank loan that eventually needs to be repaid.In fact, the broker lending the shares earns interest of a sort, much as a bank does on a loan.Once the shares have been borrowed, the short seller then sells the stock in the open market, in hopesthat the price will drop.After a period of time, the short seller then buys back the stock in order to return the borrowed stockto the lender and cover his liabilityBecause the price of the stock has declined since the sale, the investor is now eager to repurchase theshares from the market in order to cover his liability and pocket the profits.Once the stock has been returned, and the liability has been covered, the difference between the pricesold and price bought, representsthe profit to the short seller.Step 1Step 2Because the repurchase priceis lower than the initial sale price,the investor profits.BrokerShort sellerMarketThe illustration to the rightreally brings the idea home.Whether an investor profitsfrom the transaction dependsentirely on the level of the stock atsale and repurchase.Here is how things would playout in the real world:Step 4Step 3STEP 1: Short seller borrows a stock from the brokerSTEP 2: Short seller immediately sells the stock on the marketSTEP 3: Short seller buys back the stock from the marketSTEP 4: Short seller returns the borrowed stock to the broker7

Section 3: First You Borrow, Then You SellSCENARIO #1: Stock declines Sell Price (Step 2) Repurchase Price (Step 3) ProfitSCENARIO #2: Stock increases Sell Price (Step 2) Repurchase Price (Step 3) LossLet’s assume that an investor believes the price of ABC stock, currently trading at 25, will decline in thenear future. In order to profit from the decline, the investor’s first calls his broker to borrow 100 shares ofABC stock for a short sale (Step 1). He/she then immediately sells the shares in the open market and receivesa cash inflow of 2500 (Step 2).A month later, the price of ABC stock has dropped to 20 (Scenario 1) and the investor decides to “cover”his position by buying back the shares on the market for 20. He pays the 2000 to acquire the shares (Step3) and immediately returns the shares to the lender (Step 4)Because the inflow ( 2500) exceeds the outflow during the repurchase ( 2000), the investor has profited inthe amount of 500.The process really is as simple as that.However, as you have probably guessed, there are a few other things you should know.After all, why would a broker wish to lend the stock? And how is it possible that a stock is available forlending in the first place?To answer these questions, we need to understand how margin works, because without margin there isno short selling.8

Section 4:Investing on MarginTurbo Charge Your Portfolio with “Other People’s Money”In order to initiate short positions, you need a margin account. Because shorting requires borrowing,and borrowing is only possible in a margin account.Think of margin simply as an extension of credit from a brokerage house using your own securitiesas collateral. As such, selling short is a way to borrow from your broker, effectively using broker’smoney to invest.Much like a bank loan, your broker requires you to provide collateral as protection against creditrisk. Instead of taking your mortgage, for example, the broker asks you to deposit cash or marginablesecurities instead.Now, a margin account allows you to do many different types of trades, such as options and otherderivatives, debt, buying shares, and shorting a stock.The common denominator for all margin account transactions is credit, or borrowed capital.This is the essence of margin investing and it carries the benefit of magnifying the potential upside.Another example Let’s assume that both margin and a cash investor purchase 1,000 shares of ABC stock, currently tradingat 10 per share. The total purchase price thus equals 10,000 for both.But – and here is the kicker – the margin investor uses a margin loan of 5,000 from his broker, while thecash investor invests all of his own money, a total of 10,000.Purchase PriceCash OutflowMargin LoanMARGIN INVESTORCASH INVESTOR 10,000.00 5,000.00 5,000.00 10,000.00 5,000.00 5,000.00SCENARIO #1: Stock RisesSale ProceedsInvestment Return 15,000.00 ( 5K gain)100%( 5K gain on 5K outflow) 15,000.00 ( 5K gain)50% ( 5K gain on 10K outflow)SCENARIO #2: Stock DeclinesSale ProceedsInvestmetn Return 5,000.00 ( 5K loss)-100% ( 5K loss on 5K outflow)9 15,000.00 ( 5K loss)-50% ( 5K loss on 10K outflow)

Section 4: Investing on MarginHere is what happens to investment returns in both scenarios.In Scenario 1, the stock increases from 10 to 15, resulting in a total portfolio value of 15,000 forboth investors, but Because the margin investor only risked 5,000 of his own cash, the effective return on investmentis 100% ( 5K gain on 5K cash outflow). The cash investor, on the other hand, used 10,000 of his ownmoney, producing a 50% return ( 5K gain on 10K cash outflow).Because the margin investor used only 50% of his own capital, the investment has given him a100% return.But, credit can cut both ways.In Scenario 2, the 50% loss in stock value produces a 100% loss in case of a margin account and only50% loss in the cash account.Why? Because a margin investor has lost 5,000 on a 5,000 cash outflow, while a cash investor onlylost half of his initial outflow.This is the key difference between a margin account and a cash account; a margin account willalways produce outsized returns relative to a cash account, whether the price of the underlying stockincreases or decreases.As you can see, the idea behind margin trading, and short selling in general, is fairly intuitive. Onceyou have the concept in mind, the next thing you need to know is how your broker operates whenlending you money, i.e. the rules they must follow in order to protect themselves from credit risk.Let’s take a step back.Margin investing is possible because the Federal Reserve Board made it legal for a brokerage house tolend up to 50% of a security’s value to an investor, a law called Regulation T.In order to limit their losses, brokerage houses, much like banks, require collateral in place at all times.This is because collateral is the only way that the lender can maintain reasonable credit risk levels. Theydo this with something called a margin requirement.Simply put, a margin requirement is a predetermined amount of collateral that needs to be available ina margin account at all times. Here’s how it works.10

Section 5:Margin RequirementsWhat Your Broker Is ThinkingYou might have heard of the term margin call.No mystery there. It is nothing more than a demand by your broker to increase the equity value inyour account, effectively eliminating the margin deficiency by raising collateral.A margin deficiency is the result of the maintenance requirement amount exceeding the equity valuein your portfolio.Maintenance Requirement Equity Value MARGIN CALLMaintenance Requirement Equity Value NO MARGIN CALLThis is fairly intuitive.Let’s assume that you are looking to buy 10,000 worth of security ABC on margin.Before any type of buying or selling occurs, the brokerage house requires an investor to deposit aminimum margin balance. (See below)Once minimum margin has been deposited, the next step is to purchase 10,000 worth of ABC shares.As you’ve probably guessed, because the Reg. T allows the brokerage house to lend 50% of the market valueof the security, an investor is only required to deposit another 5,000 in his margin account. This is called theinitial margin and effectively allows an investor to hold 10,000 worth of stock with only 5,000 upfront cost.MARGIN REQUIREMENT LEVELS1. MINIMUM MARGIN: Minimum amount that an investor has to deposit in a newly activatedmargin account, before any trades take place. The amount normally ranges between 2,000and 5,000. Also called minimum equity requirement.2. INITIAL MARGIN: Occurs upon entry of a trade and requires that an investor must pay forat least 50% of the market price of a security which he, or she, wishes to purchase on margin.Also called Reg. T requirement.3. MAINTENANCE MARGIN: A maintenance requirement that is valid after an investor hasbought securities on margin. It is the minimum equity level that must be maintained at alltimes and is normally 25% of the total market value of securities in the margin account.IMPORTANT: broker will generally notify you regarding the margin deficiency but he, or she, is notrequired to do so. In fact, they can legally liquidate any security in your account without prior notice.11

Section 5: Margin RequirementsAs time passes, one of two scenarios can occur.Stock price can rise, in which case the investor equity value rises, thereby pushing downmaintenance margin requirement, or Stock price can decline, in which case the broker is concerned with the equity value meetingthe maintenance margin requirement. If the price declines enough to bring equity value below themaintenance margin, the broker will demand that the maintenance deficiency be closed, i.e. a broker willplace a margin call.Here is an example PURCHASE# of SharesShare Price1,000 10Market Value Margin Debt 10,000Account EquityMin. Margin 5,000 2,000 5,000After an initial deposit of 2,000 (Minimum Margin), an investor purchases 1000 shares of ABCstock for a price of 10 per share. Because the initial requirement is 50% of market value of the stock,an investor is required to deposit another 5,000 (Initial Margin). The rest is provided by the broker as aloan, in this case 5,000 (Margin Debt).STOCK GOES UPx30%# of SharesShare PriceMarket ValueMargin Debt1,000 15 15,000 5,000If we assume that the stock price increases to 15, thenthe total market value of investor’s holdings increases to 15,000. Account equity increases to 10,000 (MarketValue – Margin Debt) and maintenance margin increasesto 3,000. It is important to note that maintenance marginis calculated as a percentage of current market value, not theinitial purchase price. In our case the maintenance marginrequirement is 30% of market value, but the number canvary depending on broker and type of asset.Account Equity Maint. Margin 10,000 4,500Mrkt. Value 15,000Margin Debt 5,000Equity Value 10,000Cash Investment 5,000Net Profit 5,000ROI100%Because you paid only a portion of the purchase price of the stock but receive 100% of the net profit,you would receive the proceeds from the sale of the stock less margin debt, in our case 10,000. The12

Section 5: Margin Requirements 10,000 consists of your initial 5,000 outflow plus 5,000 return on investment. The net profit istherefore 5,000 and the return on investment is 100%, despite only a 50% increase in the stock price.Not a bad deal at all STOCK GOES DOWN# of SharesShare PriceMarket ValueMargin DebtAccount EquityMaint. Margin1,000 7 7,000 5,000 2,000 2,100If the stock price drops to 7, the market value will dropaccordingly. Account equity (market value – margin debt)will decrease, thereby lowering the maintenance margin.In our case the maintenance margin is 30%, or 2,100 (.30x 7,000). Because the maintenance margin exceeds theaccount equity, no margin call will take place. However,your net loss is 3,000 (Initial Cash Outflow – AccountEquity) with a return on investment of -60% (- 3,000 netloss / 5,000). Note that the loss of 60% doubles the 30%loss of a long-only strategy.SHARE PRICE DROPMrkt. Value 7,000Margin Debt 5,000Equity Value 2,000Cash Investment 5,000Net Loss( 3,000)ROI-60%x30%# of SharesShare PriceMarket Value1,000 5 5,000Margin Debt Account Equity 5,000Assuming that the stock drops even further to 5 per share,the account equity is wiped out and maintenance marginbecomes 1,500, or 30% of total market value. Because theaccount equity is lower than the margin requirement, thebroker will issue a margin call requiring the investor to either:a) Deposit 1,500 in cash; orb) Deposit marginable securities; orc) Liquidate stock. 0Maint. Margin 1,500Mrkt. Value 5,000Margin Debt 5,000Equity Value 0Cash Investment 5,000Net Loss( 5,000)ROI-100%The net loss to investor is 5,000, corresponding to a return on investment (ROI) of -100%. Compared toa 50% drop in stock price, the loss in a margin account is twice what it would be with a long only strategy.13

Section 6:What You Need to Know About Margin5 Things to Keep in MindAs you’ve noticed, the example above assumed that theinvestor is buying on margin, rather than selling short.MARGINABLE SECURITIESMargin requirements do change when selling short, but notby much.1. Most securities listed onthe NYSE2. Majority of NASDAQ/AMEX securitiesThere are five things to keep in mind:1. In a short sale, the investor is borrowing, not cash, butsecurities.4. OTC stocks approved bythe Federal Reserve Board2. Maintenance margin requirements are greater withshort positions then long positions.3. An investor must hold in the account 100% of thesecurity’s market value, which equals the cash receivedfrom the initial short sale plus any increase which mayhave occurred.4. In addition, under Regulation T, an investor must also hold50% of the initial value of the stock. This equates to 150%of the value of the short sale at the time the sale is initiated.5. Throughout the life of the trade, an investor is alsosubject to maintenance requirements, usually 30% ofcurrent market value.SHORT SALE3. Most mutual funds*5. Certain corporate,municipal and governmentbonds*Only after 30 days of ownershipIMPORTANT: IRA and 401-kaccounts are not marginableand may NOT be used ascollateral.Source: Wikipedia50%# of SharesShare PriceMarket ValueInit. MarginTotal Margin1,000 10 10,000 5,000 15,000Let’s assume that an investor would like to sell short 1000 shares of ABC stock currently trading at 10 per share. As discussed above, the investor would first borrow the shares from his broker and sellthem into the open market, for a total sale of 10,000. The 10,000 is immediately deposited in the shortsale margin account and cannot be used for purchase of other securities. Furthermore, an additional50% of the market value must be deposited in the account (initial margin), bringing the total marginrequirement to 15,000. The investor effectively borrows 10,000 and deposits his/her own 5,000 ascollateral. The equity in the account is therefore 5,000.14

Section 6: What You Need to Know About MarginSTOCK GOES DOWN# arginMin.MarginRate ofReturn1,000 7 7,000 8,000114% 2,10060%Once the stock moves in investors favor, dropping from 10 to 7, the account equity increasesand margin requirements lessen. Account equity is calculated by taking the initial total value andsubtracting the current market value of the position (Total Margin – Market Value). During the lifeof the trade, the broker is concerned with maintenance margin equaling 30% or higher. In otherwords, the account equity value must equal 2,100 (.30 * 8,000) or greater. Because the current margin(Account Equity/Market Value) is well in excess of the 30% margin maintenance requirement, there isno danger of a margin call taking place.If the investor wishes to cash in his/her gains, he/she would buy back shares at 7 in the open marketand return them to the lender. The 3,000 profit would result in an ROI of 60% (3,000/5,000). Of course,this does not include commission and interest paid to the broker.The important thing to keep in mind is that the account equity may not drop below a certain predetermined level, in our case 30%.STOCK GOES UP# arginMin.MarginMarginDef