Short Selling

Some investors "go long" on an investment, hoping that price will rise. To profit from the stock price going down, short sellers can borrow a security and sell it, expecting that it will decrease in value so that they can buy it back at a lower price and keep the difference. The short seller owes his broker, who usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to lend to the short seller.

For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit. This practice has the potential for an unlimited loss. For example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500.

However, the term "short selling" or "being short" is often used as a blanket term for all those strategies which allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract, or to be short a futures contract, means the holder of the position has the obligation to sell the underlying asset at a later date.

In fact, what is many times labeled short selling is options or futures activity, since this activity greatly magnifies the gain that results from a securities price loss. For example, if the next earnings release of XYZ company is going to show that its profits declined somewhat in some of its divisions, its stock might decline only 5 percent when that information is released. Someone within the company who wants to trade in inside information however would probably not be satisfied with only a 5 percent gain on his short sell and instead would buy put options or other derivatives or futures to gain possibly 20 or more percent on the decline in the stock price of XYZ.

Short sellers were blamed (probably erroneously) for the Wall Street Crash of 1929. Regulations governing short selling were implemented in 1929 and in 1940. Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick.

Some typical examples of mass short-selling activity are during "bubbles", such as the Dot-com bubble. At such periods, short-sellers sell hoping for a market correction. Food and Drug Administration (FDA) announcements approving a drug often cause the market to react illogically due to media attention; short sellers use the opportunity to sell into the buying frenzy and wait for the exaggerated reaction to subside before covering their position. Negative news, such as litigation against a company will also entice professional traders to sell the stock short.

Short selling stock consists of the following:

An investor borrows shares, but since there is a general rule in the United States that one must only borrow money based on shares up to 50 percent of the shares' value, one must deposit 50 percent of the value of the shares in cash with one's brokerage firm.

The investor sells them and the proceeds are credited to his account at the brokerage firm. The investor must "close" the position by buying back the shares (called covering) - If the price drops, he makes a profit. Otherwise he takes a loss. The investor finally returns the shares to the lender.

When you sell a security, you are contractually obliged to deliver it to the buyer. If you sell a security short, i.e. without owning it first, you will have to borrow it from a third party to fulfill your obligation. Otherwise, you will fail to deliver, the securities won't settle, and you can expect a claim from your counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income. This is called securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.

A naked short sale is selling a security short, without first ensuring that you can in fact borrow the securities somewhere. In the US, locating the securities first is often referred to as a locate. To prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) has put in place Regulation SHO which prevents investors from selling stocks short before doing a locate. Market makers do not have this restriction, as this would seriously restrict liquidity.

First, understand that short sellers can potentially lose much more than simply going long - there is a much greater risk involved in short selling than in buying stock (where typically your potential loss is limited to the amount invested).

The short seller owes his broker and must repay the shortage when he covers his position. Technically, the broker usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to loan to the short seller.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate", and it is a legal requirement that U.S. regulated broker-dealers not permit their customers to short securities without first obtaining a locate. Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Sometimes, brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker cannot borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. .

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically give short interest or the Short ratio that gives the number of shares that have been sold short as a % of the total float. Alternatively, these can also be expressed as Short interest ratio or the short ratio which is the number of shares sold short as a % of the average daily volume. These can be useful tools to spot trends in stock price movements.

An investor can also purchase a put option, giving that investor the right (but not the obligation) to sell the underlying asset (such as shares of stock) at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon (or "strike") price, which would then be higher than the current quoted spot price of the asset.

Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another so there is no possibility for any single currency to get to zero. Actually, selling short on the currency markets is identical to selling long.

Novice traders or stock traders can be confused from failure to recognize and understand this point: a contract is always long one thing and short another.

When the exchange rate has changed the trader buys the first currency again; this time he gets more of it, and pay back the loan. Since he got more money than he had borrowed initially, he earns money. Of course, the reverse can also occur.

An example of this is as follows: Let us say a trader wants to trade with the dollar and the Indian rupee currencies. Assume that the current market rate is $1=Rs.50 and the trader borrows Rs.100. With this, he buys $2. If the next day, the conversion rate becomes $1=Rs.51, then the trader sells his $2 and gets Rs.102. He returns Rs.100 and keeps the Rs.2 profit.

One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.

It is important to note that buying shares and then selling them (called "going long") has a very different risk profile from selling short. In the former case, losses are limited (the price can only go down to zero) but gains are unlimited (there is no limit on how high the price can go). In short selling, this is reversed, meaning the possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, with no upper limit. For this reason, short selling is usually used as part of a hedge rather than as an investment in its own right.

Many short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.

The risk of large potential losses through short selling inspired financier Daniel Drew to warn:

"He who sells what isn't his'n, must buy it back or go to pris'n"

Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.

Short sellers must be aware of the potential for a short squeeze. This is a sharp uptick in the price of a stock, caused by large numbers of short sellers covering their positions on that stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. (This may occur in an automated way if the short sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been sold short, but not yet covered.

On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices significant short positions, and buys many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick.

Short sellers have to deliver the securities to their broker eventually. At that point they will need money to buy them, so there is a credit risk for the broker. To reduce this, the short seller has to keep a margin with the broker.

Finally, short sellers must remember that they are betting against the overall upward direction of the market. This, combined with interest costs, can make it unattractive to keep a short position open for a long duration.

Please help improve this article or section by expanding it. Further information might be found on the talk page or at requests for expansion. This article has been tagged since May 2007.

A seller intentionally takes on directional risk in the belief that the value of the shorted asset will fall.

Further information: Hedge fund Short selling often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:

A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are

an arbitrageur who goes long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.

Short sellers are widely regarded with suspicion because, to many people, they are profiting from the misfortune of others. However, academic studies have generally lauded short-selling as an important contribution to stock market efficiency.[4] Some businesses campaign against short sellers who target them, sometimes resulting in litigation.

Advocates of short sellers say that the practice is an essential part of the price discovery mechanism. They state that short-seller scrutiny of companies' finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies' stock long. Some hedge funds and short sellers claimed that the accounting of Enron and Tyco was suspicious, months before their respective financial scandals emerged.

Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street, while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.

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