Short Selling: IntroductionHave 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: 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
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:
They must know:
Short Selling: The TransactionSuppose 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:
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:
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 RisksNow 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.
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.) 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 SellingIt'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:
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: ConclusionShort 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:
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Short Selling
Short Selling: IntroductionHave 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.) |