The Rewards - and Risks - in "going Short"

Turn away from taxes to other accepted techniques, and take a look at "going short" - a major item in the stock-market in some of the darkest bearish moments of 2000, and still a fairly popular move in mid-2004. When the market is headed down, even a prudent investor doesn't have to wait it out in hopes of better times. With some care and daring, he can go short if he's convinced that the prices of certain stocks will in the future hit new lows.

You go short - successfully - by selling borrowed shares and paying your debt later when the price of the stock has declined. You bet against the stock and thrive on someone's misfortune. Some investors question the morality of such deals. But an active investor may miss good chances for profits if he religiously refrains from short sales.

Here is what happens when you go short in a stock: Say you are convinced that XYZ stock - now at £50 - will take a slide in the next three or four months. You borrow 500 shares of XYZ from your broker and put up, say 80% of the value, or £20,000. Your broker immediately sells the 500 shares at £50, thus establishing for you an actual sale at that price. You pay the broker his usual commission on the sale, plus interest (currently about 10%) on the margin he has provided.

Thus you get advantage of the sale at £50, and owe your broker 500 shares of XYZ. If your prediction materializes and XYZ drops to, say, £30 in the next three months, you buy 500 shares at £30 and use them to pay off your £50 debt. The broker earns another commission on the purchase. And your profit on the whole deal comes to £10,000, less commissions and margin interest.

It sounds simple. But unless you're lucky, or quite skilled, you can get into real trouble by going short. As a safeguard, you can limit your possible loss when you go short by placing a stop order with your broker to buy the covering shares at a fixed price.

One obvious caution: When you buy a stock in the usual way - banking that it will go up - you can lose no more than your investment. But with a short sale there's no limit to your possible loss if the stock goes sky-high. If it goes up, you must pay that much more for shares with which to pay off your debt.

Timing is the critical element in selling short. And here the stock market chartists can help. Before you try a short sale, carefully study a stock's price and volume performance over the past year or two. This should give you a clue to the probable start of a price decline in that stock.

Also important is the basis for the decline. To be reasonably safe for shorting, the decline should grow out of some serious pressure on the stock. You must be sure that the drop isn't just a temporary reaction to overpricing, and that the basic flaw relating to the company hasn't already been discounted by the market.

One reason to go short in a stock is to pick up what can become a sizable tax break. Generally you do this when you already own the stock and make a short sale "against the box" - that is, you cover the short sale with your own original shares instead of buying new shares to cover.

Most commonly, you do this with a stock on which you have already made a gain - and at a time when you figure your investment is due for a decline. You establish your gain the moment you sell short: it's the difference between the purchase price of the original stock and the price at which you sell short. If the stock slides even below your original price, you're that much better off.

One big advantage: Though you establish your gain when you go short, you owe no taxes on it until you complete the transaction by covering the borrowed stock. This can let you shift tax liabilities from one year to another, and - depending on your situation - big savings can result.

When you go short against the box, your gain will be either long-term or short-term, depending on how long you had held the stock as of the date of your short sale. But note: When you cover a short sale in the usual manner - by buying more shares to pay off your gain is always short-term regardless of how long you stayed short or how long you owned a similar block of shares.

In and out with "puts" and "calls" When the market lunges and plunges, one of Wall Street's more arcane arts - put and call options - takes on extra appeal. Depending on how you play them, put-and-call options on a stock let you engage in out-and-out speculation, or hedge your bets to a fine degree. Some people even play around with puts and calls on a theoretical basis; they get their fun out of doing the mathematics and don't put up money. But there's no doubt that manoeuvring in the market with puts and calls can give you big leverage with little cash outlay.

When you buy a put, you get an option to sell a stock at a specific price within a fixed time limit. A call is the reverse: You get an option to buy. Beyond that come some strange combinations of puts and calls to which Wall Streeters give such names as straddles, spreads, strips, and straps. Says Larry Botts, one of the Street's leading put-and-call specialists: "The shame is that few investors really know the ins and outs. They might find some fascinating chances, especially in a volatile market."

The basic idea is simple. If you think the price of a stock will decline, you buy a put option that lets you sell the stock later at its current price. If you think the stock is going up, you purchase a call to buy at the current price before the option's expiration date. Thus you can speculate to pick up capital gains, to protect paper profits - or to limit a loss on a position you hold.

Puts and calls always cover a round lot of 100 shares, though you aren't limited to any fixed number of lots. The time of the option runs 30, 60, or 90 days, or six months plus 10 days, and some run to a year.

One lure is that the option takes less capital than buying the stock itself, and it offers a limited risk. The price of the put or call varies; it depends on the stock's price, the time element, and demand among buyers for options. Usually you pay 8% to 15% of the current market price of a 100-share lot

For instance, if you buy a call for 15% of a stock's price and the stock rises 30%, you double your money upon exercising the option. If the stock collapses, you can lose no more than you paid for the call. You don't even have to exercise the option to make a profit. You can simply resell your put or call and maybe get a tax break in the bargain.

Say you own XYZ stock and are convinced that it's going down. You go to your own broker - or directly to a put-and-call broker - and buy a put. XYZ sells at £100; you buy the put for 90 days for perhaps £800, covering 100 shares - or 8% of the market price. You are guaranteed a buyer at £100 a share regardless of how the stock moves within the next 90 days.

Assume XYZ drops to £60. You then buy 100 shares at that price and exercise your option to sell them at £100. This brings a gross profit of £40 per share, or £4,000. Subtract the £800 cost of the put plus about £100 in commissions, and you have a net profit on the deal of £3,100. On the other hand, if your guess goes wrong and XYZ goes up, you can lose only £800.

If instead you had made a straight short sale and you covered when XYZ hit, say, £120, your loss would be £2,000 plus commissions. And the loss on the short sale could be unlimited if you stalled while XYZ went higher and higher.

Suppose instead that you feel bullish - you're sure that XYZ stock will go up. You reverse signals and buy a call for £800. Say XYZ goes from £100 to £120 a share. You exercise the option, buying 100 shares at £10,000 and sell them on the market for £12,000 - with a gross profit of £2,000 or net profit of about £1,100.

Straddles are double options that combine a put and call on the same stock at the same price. You don't know which way the stock is going but are pretty sure it will move. You hope that the action either way will be enough to outweigh the double cost of buying two options.

If you want a clear-cut, 160-page explanation, see John D. Cunnion's How to Get Maximum Leverage from Puts and Calls. It could be a highly profitable venture for anybody past the novice stage (Business Reports, 1 West Ave., Larchmont, N.Y.).

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Stock Splits And Dividends

Stock splits - and dividends paid in stock instead of in cash are another tax-related portfolio problem. Each year a rash of new splits is announced, usually during the annual corporate-meeting "season" in early springtime.

First, note that the tax rules are exactly the same for splits and stock dividends. In both cases, generally, you pay no tax simply for picking up the added shares. And you needn't report the deal on your form 1040. But there's one exception - and it's rare: If you have a choice of either cash or stock, you pay tax - even if you decide to take the shares.

When you sell split or dividend shares, you have to figure your cost basis to arrive at taxable profit.... see: Stock Splits And Dividends