Description

This article is from the A Guide to Closed-End Funds (CEFs).

Investing in Closed-End Funds: Short Selling

A margin account may also be used for shorting CEFs: that is, hoping to profit from an anticipated decline in the market price of the CEF. The mechanics of shorting are as follows: you borrow the shares from your broker and sell them, with the understanding that at a later date you will buy back the shares (called covering your short position) and return them to the broker. If you sell them at a higher price, and buy back later at a lower price you make a profit. The requirements for short selling may vary with brokers, however, you will have to deposit funds or securities to make sure you have the capacity to buy back the shares or cover your short position.

Short selling is inherently riskier than buying stocks: when you buy stocks there is no limit to your profit and a limit to your loss (the stock can't go below zero); when you short sell there is no limit to your loss (the stock can keep rising) and a limit to your profit (when the stock hits zero). There are many other considerations:

1. The brokerage firm has to have shares available to lend to you to short.
2. Short selling may be allowed only during "up ticks", that is, in simple terms, when the price is moving up.
3. In some cases, you may be forced to cover, if the broker has to return the shares he lent you. This may occur when a "short squeeze" develops, that is, a large player or players call in their shares, forcing shorts to cover at increasingly higher prices. This is especially of concern with thinly traded, illiquid stocks.
4. If the CEF rises in price, your broker may ask you to deposit additional funds or securities or cover a portion of your short position to meet the maintenance requirements.
5. If the CEF issues a dividend or distribution (and many make large distributions), funds to pay the dividend or distribution must be available in your account (the price of the CEF will, usually, drop by the amount of the dividend or distribution).
6. With the recent spate of rights offerings in CEFs, the investor should be aware that if he is short the CEF when it goes ex-rights, he will be short the rights (and the CEF will drop in price, correspondingly, as with the dividend). If the rights are transferable, that is, there is a market for them, the investor can cover his short position by buying the rights on the market. If the rights are not transferable, the rights may be exercised against the short seller, that is, he has to provide shares of the CEFs according to the terms of the rights offerings to the person subscribing to the rights. Since the terms are usually attractive to encourage investors to subscribe to the rights offerings, the short seller is at a disadvantage.

Despite these caveats, for aggressive investors, short selling may be an effective tool when the market is overvalued and the CEFs are trading at unusually high premiums. In such cases, the investor has two swords: an anticipated drop in the market and an anticipated shift in discount to the CEF's usual discount, and one protective armor: if the market rises further, the market price may not; instead, the premium may drop to more acceptable levels.

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