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Short Selling

Short Selling: Introduction

Have you ever been absolutely sure that a stock was going to decline and wanted to profit from its regrettable demise? Have you ever wished that you could see your portfolio increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling. (For related reading, see When To Short A Stock.)

Short selling is not complex, but it's a concept that many investors have trouble understanding. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.

Short selling involves many unique risks and pitfalls to be wary of. The mechanics of a short sale are relatively complicated compared to a normal transaction. As always, the investor faces high risks for potentially high returns. It's essential that you understand how the whole process works before you get involved.


Short Selling: What Is Short Selling?


First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most commonly used. They serve as an intermediary between the investor and the seller and often charge a fee for their services.
When using a broker, you will need to set up an account. The account that's set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends you a portion of the funds at the time of purchase and the security acts as collateral.

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept. (To learn more, read Benefit From Borrowed Securities.)

Still with us? Here's the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security.

Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price. (To learn more about stock splits, read Understanding Stock Splits.)

Short Selling: Why Short?

Generally, the two main reasons to short are to either speculate or to hedge.

Speculate
When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high-risk investment. Speculation has been perceived negatively because it has been likened to gambling. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it. (For more insight, see What is the difference between hedging and speculation?)

Speculators can assume a high loss if they use the wrong strategies at the wrong time, but they can also see high rewards. Probably the most famous example of this was when George Soros "broke the Bank of England" in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion. (For more on this trade, see The Greatest Currency Trades Ever Made.)

Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.

Hedge
For reasons we'll discuss later, very few sophisticated money managers short as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.

Hedging can be a benefit because you're insuring your stock against risk, but it can also be expensive and a basis risk can occur. (To learn more about hedging, read A Beginner's Guide To Hedging.)

Restrictions
Many restrictions have been placed on the size, price and types of stocks traders are able to short sell. For example, penny stocks cannot be sold short, and most short sales need to be done in round lots. The Securities Exchange Commission (SEC) has these restrictions in place to prevent the manipulation of stock prices.

As of January 2005, short sellers were also required to comply with the rules set in place by "Regulation SHO", which modernized the rules overseeing short selling and aimed to provide safeguards against "naked short selling." For instance, sellers had needed to show that they could locate and get the securities they intended to short. The regulation also created a list of securities showing a high level of persistent sales to deliver.

In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines. The rule has been around since the creation of the SEC in 1934. One of the reasons it was put in place was to slow rapid and sudden declines in share prices that can occur as a result of short selling.

In July of 2008, the SEC used its emergency powers to put an end to market manipulations, such as spreading negative rumors about a company's performance and sharp price declines. The markets had been volatile as a result of the of mortgage and credit crisis, and the SEC wanted to establish a renewed confidence. For a month, it didn't allow naked short selling on the stocks of 19 major investment and commercial banks, which included the mortgage finance companies Fannie Mae and Freddie Mac.


The SEC took further measures in September of 2008, once again using its emergency authority to issue six orders to minimize abuses. This included a move to halt short selling in shares of 799 companies in cooperation with the United Kingdom's Financial Service Authority. 170 companies were later included in the ban, which ended after the passage of the $700 billion U.S. bailout plan in October 2008. Another order required short sellers get a sale and immediately close it by making sure the shares were delivered. It later became a rule.

Who Shorts?
Some insiders indicate that it takes a certain type of person to short stocks.

Many short sellers have been depicted as pessimists who are rooting for a company's failure, but they've also been described as disciplined and confident in their judgment.

Sellers are typically:
  • wealthy sophisticated investors
  • hedge funds
  • large institutions
  • day traders
Short selling isn't for everyone. It involves a great amount of time and dedication. Short sellers need to be informed, skilled and experienced investors in order to succeed.

They must know:
  • how securities markets work
  • trading techniques and strategies
  • market trends
  • the firm's business operations

Short Selling: The Transaction


Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let's take a look at how this transaction would unfold.

Step 1
: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says "short sale" and "buy to cover." In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:
  • the brokerage firm's own inventory
  • the margin account of one of the firm's clients
  • another brokerage firm
You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan. (To learn more, read the Margin Trading tutorial.)

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

One of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $2,500


The Stock Price Rises (stock goes to $90)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $90 -$9,000
Your Profit -$2,500

Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you expect it to (just as with buying long). Shorter sellers use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven't been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn.

Short Selling: The Risks

Now that we've introduced short selling, let's make one thing clear: shorting is risky. Actually, we'll rephrase that. Shorting is very, very risky. It's not unlike running with the bulls in Spain: you can either have a great time, or you can get trampled.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short sale result in some unique risks.
  1. Short selling is a gamble. History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

So, if the direction is generally upward, keeping a short position open for a long period can become very risky. (To learn more, read Stocks Are No.1 and The Stock Market: A Look Back.)

  • Losses can be infinite. When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go. For example, if you short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece, you end up losing $2,500. On the other hand, a stock can't go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value.

  • Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to a margin call, and you'll be forced to put in more cash or liquidate your position. (We won't cover margin in detail here, but you can read more in our Margin Trading tutorial.)

  • Short squeezes can wring the profit out of your investment. When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast. (To learn more, see Short Squeeze The Last Drop Of Profit From Market Moves.)

  • Even if you're right, it could be at the wrong time. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.Take the dotcom bubble, for example. Sure, you could have made a killing if you shorted at the market top in the beginning of 2000, but many believed that stocks were grossly overvalued even a year earlier. You'd be in the poorhouse now if you had shorted the Nasdaq in 1999! That's when the Nasdaq was up 86%, although two-thirds of the stocks declined. This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq. However, it wasn't until three years later, in 2002, that the Nasdaq returned to 1999 levels.

  • Momentum is a funny thing. Whether in physics or the stock market, it's something you don't want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you wouldn't jump in front of a pack of stampeding bulls, don't fight against the trend of a hot stock.

    Short Selling: Ethics And The Role Of Short Selling

    It's safe to say that short sellers aren't the most popular people on Wall Street. Many investors see short selling as "un-American" and "betting against the home team" because these sellers are perceived to seek out troubled companies.
    Some critics even believe that short sales are a major cause of market downturns, such as the crash in 1987. There isn't a whole lot of evidence to support this, as other factors such as derivatives and program trading also played a massive role, but two years after the crash, the U.S. government held the 1989 House subcommittee hearing on short selling. Lawmakers wanted to look at the effects short sellers had on small companies and examined the need for regulation after allegations of widespread manipulation by short sellers of over-the-counter stocks. SEC officials reassured the public that manipulations hadn't been uncovered and more rules would be put in place. (To learn more, read Questioning The Virtue Of A Short Sale and The Uptick Rule: Does It Keep Bear Markets Ticking?) But despite its critics, it's tough to deny that short selling makes an important contribution to the market by:
    • Adding liquidity to share transactions. The additional buying and selling reduces the difference between the price at which shares can be bought and sold.
    • Driving down overpriced securities by lowering the cost to execute a trade
    • Increasing the overall efficiency of the markets by quickening price adjustments
    • Acting as the first line of defense against financial fraud. For instance, in 2001, famed short seller James Chanos identified fraudulent accounting practices that occurred with the Enron Corporation, an energy-trading and utilities company. The company's activity became known as the Enron scandal when the company was found to have inflated its revenues. It filed Chapter 11 bankruptcy at the end of 2001. (To learn more about this scandal, see The Biggest Stock Scams Of All Time.)

    While the conflicts of interest from investment banking keep some analysts from giving completely unbiased research, work from short sellers is often regarded as being some of the most detailed and highest quality research in the market. It's been said that short sellers actually prevent crashes because they provide a voice of reason during raging bull markets.However, short selling also has a dark side, courtesy of a small number of traders who are not above using unethical tactics to make a profit. Sometimes referred to as the "short and distort," this technique takes place when traders manipulate stock prices in a bear market by taking short positions and then using a smear campaign to drive down the target stocks. This is the mirror version of the pump and dump, where crooks buy stock (take a long position) and issue false information that causes the target stock's price to increase. Short selling abuse like this has grown along with internet trading and the growing trend of small investors and online trading.

    Short Selling: Conclusion

    Short selling is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling provides a sizable opportunity with a hefty dose of risk. We hope this tutorial has enabled you to understand whether it's something you would like to pursue. Let's recap:

    • In a short sale, an investor borrows shares, sells them and must eventually return the same shares (cover). Profit (or loss) is made on the difference between the price at which the shares are borrowed compared to when they are returned.
    • An investor makes money only when a shorted security falls in value.
    • Short selling is done on margin, and so is subject to the rules of margin trading.
    • The shorter must pay the lender any dividends or rights declared during the course of the loan.
    • The two reasons for shorting are to speculate and to hedge.
    • There are restrictions as to what stocks can be shorted and when a short can be carried out (uptick rule).
    • Short interest tells us the number of shares that have already been sold short in a security.
    • Short selling is very risky. You can lose more money than you invest but are limited to 100% profit on the upside.
    • A short squeeze is when a large number of short sellers try to cover their positions at the same time, driving up the price of a stock.
    • Even though a company is overvalued, it may take a long time for it to come back down. Fighting the trend almost always leads to trouble.
    • Critics of short selling see it as unethical and bad for the market.
    • Short selling contributes to the market by providing liquidity, efficiency and acting as a voice of reason in bull markets.
    • Some unethical traders spread false information in an attempt to drive the price of a stock down and make a profit by selling short.








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