Short Selling

March 24th, 2014 Leave a comment Go to comments

05.21.2010 original publish date
09.29.2012 update
03.24.2014 minor update


Short Selling

Investor Education Series by Net Advisor

We hear a lot about short selling, or “shorts” in the stock market.

In short (pun intended):
If you are short a stock, you believe the stock price will fall. You profit if the stock falls in price. If the stock goes up, you begin to take losses.

Essentially, you sell a stock you don’t own. This is what throws people right away. What??? I sell something I don’t own? Yes.

1. A short seller borrows that stock from their stock broker and sells it.

2. At one point the short seller has to replace the borrowed stock by purchasing the same number of shares they had previously sold.

If one buys back that short stock at a LOWER price than they sold it, they make a profit.

If one buys back that short stock at a HIGHER price than they sold it, they have a loss.

Goal of short selling:
“Sell high, Buy low.”

Most people only invest this way:
“Buy low, sell high.”

Short Selling Example:
Short 100 shares XYZ @ 65

If stock is: $60.00

You have an unrealized gain of $5.00 per share: ($65.00 price you shorted the stock minus $60.00 current price = $5.00, the difference in price). Then, $5.00 per share gain x 100 shares is a $500.00 unrealized gain.

If stock is: $70.00

You have an unrealized loss of $5.00 per share: ($65.00 price you shorted the stock minus $70.00 current price = -5.00 the difference in price). -$5.00 per share loss x 100 shares is $500.00 unrealized loss.

The gain or loss is “unrealized” because the trade is still open. When you close the trade (“Buy to cover”) for a short stock position, or “sell” a long position, then the gain or loss becomes realized.

Entering a short sale:
To begin a short sale, one would enter the following with their broker: “Sell to Open.”

Exiting a short sale:
To close or exit a short sale, one would enter the following with their broker: “Buy to Cover” or “Buy to Close.”

Rules for Short Selling:
In order to open a short position one must first deposit a minimum of $2,000 in their brokerage account. Brokerage firms may require you to deposit more than the SEC’s $2,000 minimum. Why? The brokerage firm is also taking a risk if you are unable to pay. We’ll get into that later. However, if $2,000 is all you have, don’t bother shorting. It is not worth the risk.

When a stock has been sold short, the broker has loaned the stock out to the short seller in what is called the hypothecation agreement required for a margin account. Margin accounts are required for short selling because one is borrowing stock from someone else. A client must sign hypothecation agreement which may be written in the  margin account before a short sale can take place. A brokerage firm’s compliance officer must also pre-approve the client before they can begin short selling. A stock broker is not the one who makes this decision.

If an investor has a margin account, they give written consent, per terms of the margin (hypothecation agreement) whereas the broker can lend out any and all marginable stocks without further notice.  It also allows the investor to be able to use leverage and buy more stock if they want to.

The broker will tell you if a stock is marginable or not. If it is, it can be shorted. If it is not, it cannot be shorted.

How Much Can I borrow?
Margin comes under what is called Regulation T (“Reg T”) of the Federal Reserve Board. Generally, typical initial margin one can borrow up to 50% (double) of the current value of marginable securities.

examples:
$2,000 in the account can borrow up to $4,000 marginable securities.

$10,000 in the account can borrow up to $20,000 marginable securities.

$100,000 in the account can borrow up to $200,000 marginable securities, etc.

Margin Requirements
One must maintain no less than 25% of the total market value of the securities in your margin account at all times. Brokerage firms can require a higher than 25% minimum margin requirement on any marginal stock. A stock that has a higher margin requirement means one could be subject to deposit more cash or marginable securities in their brokerage account.

What if I am short and the stock goes up?
You begin to take losses. Remember the goal of short selling it to sell high and buy low. You have to buy back or “cover” that stock you sold by going in the market and buying it back, hopefully at a lower price than you sold it. The difference is you gain or loss.

Short selling can be a useful tool, but it is a far the more risky strategy because in theory, a stock has no limit how high it could possibly go, therefore the potential loss in a short sell is unlimited.

Margin Calls
Anytime the stock RISES above the minim margin requirement, one could get what is called a Maintenance call, or Margin call, or a Fed call. Basically you are taking losses (the short stock is going up – a lot), and you have to come up with more cash or marginable securities in their brokerage account fast (usually within 1-3 business days) or the broker can force you to cover (close in part of all) of any position in your brokerage to meet that required margin call. The brokerage firm can do this anytime per the hypothecation agreement. By satisfying the call, you can maintain the short position. However, if the stock continues to climb, you could continue receiving more margin calls, thus you have to come up with more cash or marginable securities in their brokerage account in order to keep the position.

Short Squeeze
A stock where a large number of people have short positions suddenly moves substantially higher say 20% or more in a short period of time, say 1-7 days, can then create what is called a short squeeze. A short squeeze is not a brief hug from someone, but the term comes from that. If you briefly squeeze someone really, really tight, it could hurt a little. In short selling, a short squeeze is just that. Your are short a stock, and suddenly it surges higher.

A short squeeze can happen at any time. Without getting too technical, a short squeeze is more likely to occur when there is a massive amount of shares being held in short position, called short interest and the stock has a short term surge in price.

Find NASDAQ Short Interest Ratios

Find NYSE Short Interest Ratios (subscription service of NYSE Euronext, Inc.)

What is short interest ratio.

As the stock surges, short sellers can face those margin calls, forcing them to put in more money or marginable securities or they are forced out of the position. Remember when short sellers close out of a position, they enter an order to buy to cover, effectively placing a buy order on the stock. Then when massive shorts are covering all at once, that sends massive buy orders for the stock, propelling the stock even higher, forcing even more short sellers to cover, hence a short squeeze.

Dividends.
If you are short a stock and the stock has a dividend be careful and watch for the ex-dividend date as you could end up seeing a debit from your cash account with your broker.

Hypothetical Example:
Short 100 shares of XYZ.

It has a quarterly dividend of .25 cents.

Entered the short on July 5.

Stock goes ex-dividend on July 21.

If you are still holding that short position on July 21, your broker will debit your account by the number of shares  you have short on that particular stock times the amount of the quarterly dividend. In this case it will be $25.00

100 shares x .25 cents = $25.00

Who gets this money?
The person whom you had borrowed the stock from gets the money. The other side of the trade is someone is still long the stock your shorted. As they are still long, they are entitled to that dividend. Short sellers are NEVER entitled to dividends because they don’t OWN the stock. The debit occurs on whatever pay date is set by the issuing stock company.

Why Bother Short Selling?
As we know stocks don’t move in a straight line up. At some point we have corrections, recessions, bankruptcies, etc. Short selling is a strategy to profit on a stock that may be overpriced in the near term. There are other strategies such as using options to do this, and limit risk better, but that is another class. Also keep in mind that stocks tend to move down faster than they go up. This is where short sellers can make money quickly if they can time their investment properly.

Short selling also provides liquidity to the markets. My experience suggests that markets with high liquidity will tend to favor fairer pricing.

Example of constricting liquidity from markets – Result: Decreased market value. Stock prices tend to fall.

Example of markets that are normally  illiquid – Result: Poor buy and sell pricing. Pay more to get in, get less getting out.

Short selling can also be used to hedge long potions in a portfolio.
If one is generally long the stock market, they may want to incorporate a strategy to protect short term downside risk. I actually prefer to use options for this, again that is another class.

“In Short”
Short selling may sound risky, and there is much higher risk than just buying the stock as 100% of the risk is placed on the person shorting the stock, not the person owning the stock long. However short selling done right can also be a way to hedge risk, or just profit from a falling stock. One should do proper research or get expert help before attempting to short stocks or other securities. Generally for those who are short a security, it is strongly suggested that they watch the trade very closely, and not passively unless the short is intended to be a longer term position. But even then, when engaging in more risky strategies, it is always best to pay close attention to the security as at some point, you will want to take profit or curt losses.

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