Short (finance) - Misplaced Pages

This is an old revision of this page, as edited by Lastexit (talk | contribs) at 18:57, 22 April 2006 (adding material removed from below). The present address (URL) is a permanent link to this revision, which may differ significantly from the current revision.

Revision as of 18:57, 22 April 2006 by Lastexit (talk | contribs) (adding material removed from below)(diff) ← Previous revision | Latest revision (diff) | Newer revision → (diff)

You must add a |reason= parameter to this Cleanup template – replace it with {{Cleanup|December 2005|reason=<Fill reason here>}}, or remove the Cleanup template.

In finance, short selling is a way to profit from the price of a stock or other security declining. Most investors "go long" on an investment, hoping that price will rise. To profit from the stock price going down, a short seller can borrow a security and sell it, hoping that it will decrease in value so that they can buy it back at a lower price and keep the difference. 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 $5 per share, the short seller would then buy 100 shares back for $500, return the shares to their original owner, and make a $500 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 including the buying and selling of options known as "puts and calls". 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 satisifed 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.

History

Short selling has been a target of ire since at least the 17th century when England banned it outright. 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.

Moreover, less than 5% of all shorts are done by public investors and traders, whereas at least 95% of short sales are done by broker-dealers and market makers who do not even always have to own shares to sell them (i.e. Naked Short Selling).

The term "short" was in use from at least the mid-19th century. It is commonly understood that "short" is used because the short seller is in a deficit position with his brokerage house.

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 sharp downturn. President Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. Legislation introduced in 1940 banned mutual funds from short selling (this law was lifted in 1997).

When Wall Street "downgrades" a stock, one may reasonably assume that interested parties have already established a short position in (i.e. sold short) the stock being downgraded, as invariably the stock drops or even plummets when the "downgrade" hits the wire. Therefore, public investors are typically too late to short by the time the "downgrade" is heard on the news.

Some typical examples of mass short-selling activity are during "bubbles", such as the Internet bubble, the cigar smoking fad or the Pokémon craze (all of which happened between 1995 and 2000 in the U.S.). At such periods, short-sellers sell hoping for a market correction. 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.

Mechanism

Short selling stock consists of the following:

You borrow 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 shares value in cash with one's brokerage firm.
You sell them and the proceeds are credited to your account at the brokerage firm.
You must "close" the position by buying back the shares (called covering) - If the price drops, you make a profit. Otherwise you make a loss.
You finally return the shares to the lender.

Concept

Short selling is the opposite of "going long". The short seller takes a fundamentally negative, or "bearish" stance, anticipating that the price of the shorted stock will fall (not rise as in long buying), and it will be possible to buy at a lower price whatever was sold, thereby making a profit ("selling high and buying low," to reverse the adage). The act of buying back the shares which were sold short is called 'covering the short'. Day traders and hedge funds will often use short selling to allow them to profit on trading in stocks which they believe are overvalued, just as traditional long investors attempt to profit on stocks which are undervalued by buying those stocks.

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.

Example: Borrowing 100 shares from someone, selling them immediately at $1.00 - when the stock drops, you buy them back for $0.50 and give the 100 shares back to the original owner keeping the profit.

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 can not 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. In cases where the customer has not fully paid for the long position (meaning, the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.

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. Alternately, 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.

Fees

When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service. The fee is typically accrued daily and charged monthly, starting on the day that the short sale settles, and concluding on the day that the short position is "closed out". This adds incremental "short financing cost" to the strategy of short selling, and therefore decreases the profit potential of short selling. It should also be noted that contrary to standard finance theory, the short seller often does not enjoy the benefits of the proceeds of the short sale to earn interest or reduce outstanding margin amounts. The brokers generally do not pass this benefit on to the retail client, unless the client is very large.

Markets

Hedge funds

It should be noted that short selling by hedge funds frequently represents only one leg of a more complex set of transactions which fall into a broad range of investment strategies (see hedge fund).

Futures contracts

When dealing with futures contracts, being 'short' means having the right or obligation to deliver something (of course, one may intend to buy back the contract). This is often an instrument used by producers to fix the price of goods they have yet to produce. It may just as well be used by speculators. In this case, there is no borrowing of stock involved (unless there is, as when speculators borrow stock from a broker to go short).

Note: One can also purchase a put option giving one the right (but not the obligation) to sell one's shares at a fixed price. In the event of a market decline, one could then oblige the counterparty to buy the stock at the agreed upon price, which would be higher than the current quoted price.

Currency

To sell currencies short you borrow a currency and buy another currency with it. It's important to note that in a currency forward, one is always short one currency and long another. Much confusion can be gained from not noticing this point: a contract is always long one thing and short another.

When the exchange rate has changed you buy the first currency again; this time you get more of it, and pay back the loan. Since you got more money than you had borrowed initially, you earn money. Of course, as for the reverse, the reverse.

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.

There is no formal loan: it's your good name; you agree that you compensate if your trade goes bad. As far as you are speculating: the broker will check your credit; what otherwise you do, is up to you. Of course, if one has a history of defaulting on brokers, they have little chance of obtaining loans in the future.

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.

Risk

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.

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.

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.

Short sellers must also be aware of the potential for liquidity squeezes. This occurs when a lack of potential supply, or an excess of coverers, makes it difficult to cover the short sellers' position. 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.

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.

Strategies

Against the box

One variant of selling short involves a long position. "Selling short against the box" is holding a long position on which one enters a short sell order. The term box alludes to the days when a safe deposit box was used to store (long) shares. The purpose of this technique is to lock in paper profits on the long position without having to sell that position (and possibly incur taxes if said position has appreciated). Whether prices increase or decrease, the short position balances the long position and the profits are locked in (less brokerage fees and short financing costs).

Death spiral financing

If given the right investment options, an investor can sell short a company's stock, depress the price, and use that depression to borrow more stock to sell short. This, in turn, drives the price of the stock towards zero, and reduces the company's value. This practice is known as Death spiral financing.

Opinions

Short sellers have a negative reputation to some. Some businesses campaign against short sellers who target them, sometimes resulting in litigation. Sometimes short sellers have been accused of creating bear raids by selling blocks of shares that they do not own.

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.

The regulatory response

Responding to concerns over short-selling, the U.S. Securities and Exchange Commission (SEC) instituted an uptick rule in reaction to the Crash of 1929. The rule provies that a short seller cannot sell a stock short unless on an uptick or a zero-plus tick; this means the stock can only be sold short if the last non-zero "tick" (i.e. trade price) was higher than the preceding one. In doing so, U.S. market regulators are trying to make sure that short sellers are not, by themselves, causing the price depreciation, and that downwards pressure on the stock price is balanced by new buying demand.

In the U.S., Initial Public Offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure a degree of price stability during a company's initial trading period. However, some penny stock brokerages (also known as bucket shops) have used the lack of short selling during this month to pump and dump thinly traded IPOs. Canada and other countries do allow selling IPOs (including U.S. IPOs) short.

On 2003-10-29 the SEC announced a one year pilot program to suspend the uptick rule for 1000 listed and NASDAQ traded stocks selected from the 3000 most liquid securities.