Short
selling or "shorting" is the practice of selling
securities the seller does not then own, in the hope of
repurchasing them later at a lower price. This is done in
an attempt to profit from an expected decline in price of
a security, such as a stock or a bond, in contrast to the
ordinary investment practice, where an investor "goes long,"
purchasing a security in the hope the price will rise.
The
term "short selling" or "being short" is often also 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.
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Concept
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.[1] The lender of the shares does not
lose the right to sell the shares. While the shares are lent,
two investors have a right to sell the same shares. This has happened
in 2007 in the UK with dramatic results, when shares in a Bank,
Northern Rock, were £12 in February 2007 and £2 in September.
Short sellers made over £1 billion in about seven months.[2]
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
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.
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 stock borrowed by U.S. brokers comes 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. 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.
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 report the "short interest" of a stock,
which gives the number of shares that have been sold short as
a percent of the total float. Alternatively, these can also be
expressed as the short interest ratio, which is the number of
shares sold short as a multiple of the average daily volume. These
can be useful tools to spot trends in stock price movements.
Example
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 losses as well. 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.
Because a short is the opposite of a long (normal) transaction,
everything is the mirror opposite compared to the typical trade:
the profit is limited but the loss is unlimited. Since the stock
cannot be repurchased at a price lower than zero, one can only
profit 100% from the transaction. However, because there is no
ceiling on how much the stock price can go up (thereby costing
short transactions money in order to buy the stocks back), an
investor can theoretically lose an infinite amount of money if
a stock continues to rise up. Also, in actual practice, as the
price of XYZ Company began to rise, the short seller would eventually
receive a margin call from the brokerage, demanding that the short
seller either cover his short position or provide additional cash
in order to meet the margin requirement for XYZ Company stock.
History
Short selling
has been a target of ire since at least the eighteenth century
when England banned it outright. It was perceived as a magnifying
effect in the violent downturn in the Dutch tulip market in the seventeenth century.
The term "short"
was in use from at least the mid-nineteenth 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
the United States 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; this was known as the uptick
rule, and was in effect until 2007. President Herbert 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). A few years later, in 1949, Alfred Winslow
Jones founded a fund (that was unregulated) that bought stocks
while selling other stocks short, hence hedging some of the market
risk, and the hedge fund was born.[3]
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 irrationally
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. Because both
the short seller and the original long holder can sell the same
shares at the same time, selling pressures can be artificially
magnified during such times, causing larger price drops than would
be normally justified by the negative news.
During the
Dot-com bubble, shorting a start-up company could backfire since
it could be taken over at a higher price than what speculators
shorted. Short-sellers were forced to cover their positions at
acquisition prices, while in many cases the firm often overpaid
for the start-up.
Mechanism
Short selling
stock consists of the following:
- An investor
borrows shares. (If required by law, the investor first ensures
that cash or equity is on deposit with his brokerage firm as
collateral for the initial short margin requirement.)
- 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.
Securities
lending
-
When a security
is sold, the seller is contractually obliged to deliver it to
the buyer. If a seller sells a security short without owning it
first, the seller needs to borrow the security from a third party
to fulfill its obligation. Otherwise, the seller will "fail to
deliver," the transaction will not settle, and the seller is subject
to a claim from its counterparty. Certain large holders of securities,
such as a custodian or investment management firm, often lend
out these securities to gain extra income, a process known as
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.
Sources
of short interest data
Time delayed
short interest data is available in a number of countries, including
the US, the UK, Hong Kong and Spain. Some market participants
(like Data Explorers Limited) believe that stock lending data
provides a good proxy for short interest levels. The amount of
stocks being shorted on a global basis has increased in recent
years for various structural reasons (e.g. the growth of 130/30
type strategies). News on short positions is still sparse but
various blogs including Seeking Alpha, Marketbeat, Short Stories
and Shortsqueeze provide ad hoc reporting.
Naked
short sale
-
A naked short
sale is selling a security short without first ascertaining that
one can borrow the security. In the US, making arrangements to
borrow 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.
Fees
When a broker
facilitates the delivery of a client's short sale, the client
is charged a fee for this service, usually a standard commission
similar to that of purchasing a similar security.
If the short
position begins to move against the holder of the short position
(i.e., the price of the security begins to rise), money will be
removed from the holder's cash balance and moved to his or her
margin balance. If short shares continue to rise in price, and
the holder does not have sufficient funds in the cash account
to cover the position, the holder will begin to borrow on margin
for this purpose, thereby accruing margin interest charges. These
are computed and charged just as for any other margin debit.
When a security's
ex-dividend date passes, the dividend is deducted from the shortholder's
account and paid to the person from whom the stock was borrowed.
For some brokers,
the short seller may not earn interest on the proceeds of the
short sale or use it to reduce outstanding margin debt. These
brokers may not pass this benefit on to the retail client unless
the client is very large. This means if an individual short-selling
$1000 of stock will lose the interest to be earned on the $1000
cash balance in his or her account.
Markets
Futures
and options contracts
When trading
futures contracts, being 'short' means having
the legal obligation to deliver something at the expiration of
the contract, although the holder of the short position may alternately
buy back the contract prior to expiration instead of making delivery.
Short futures transactions are often used by producers of a commodity
to fix the future price of goods they have not yet produced. Shorting
a futures contract is sometimes also used by those holding the
underlying asset (i.e. those with a long position) as a temporary
hedge against price declines. Shorting futures may also be used
for speculative trades, in which case the investor is looking
to profit from any decline in the price of the futures contract
prior to expiration.
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.
Currency
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. In this way selling short on the
currency markets is identical to selling long on stocks.
Novice traders
or stock traders can be confused from failure to recognize and
understand this point: a contract is always long in terms of one
medium 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.
Risk
Note: this
section doesn't apply to currency markets
It is important
to note that buying shares (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. When the price
of a stock rises significantly, some people who are short the
stock will cover their positions to limit their losses (this may
occur in an automated way if the short sellers had stop-loss orders
in place with their brokers); others may be forced to close their
position to meet a margin call; others may be forced to cover,
subject to the terms under which they borrowed the stock, if the
person who lent the stock wishes to sell and take a profit. 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.
Strategies
Speculation
Hedging
Short selling
often represents a means of minimizing the risk from a more complex
set of transactions. Examples of this are:
- a farmer
who has just planted his wheat wants to lock in the price at
which he can sell after the harvest. He would take a short position
in wheat futures.
- a market
maker in corporate bonds is constantly trading bonds when clients
want to buy or sell. This can create substantial bond positions.
The largest risk is that interest rates overall move. The trader
can hedge this risk by selling government bonds short against
his long positions in corporate bonds. In this way, the risk
that remains is credit risk of the corporate bonds.
Arbitrage
- 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 buys long futures contracts on a US Treasury security, and
sells short the underlying US Treasury security.
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).
U.S. investors
considering entering into a "short against the box" transaction
should be aware of the tax consequences of this transaction. Unless
certain conditions are met, the IRS deems a "short against the
box" position to be a "constructive sale" of the long position,
which is a taxable event. These conditions include a requirement
that the short position be closed out within 30 days of the end
of the year and that the investor must hold their long position,
without entering into any hedging strategies, for a minimum of
60 days after the short position has been closed.
Opinions
Short sellers
are widely regarded with suspicion because, in the views of many
people, they are profiting from the misfortune of others. 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.[4]
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. Financial researchers at Duke University
have provided statistically significant support for the assertion
that short interest is an indicator of poor future stock performance
and that short sellers exploit market mistakes about firm's fundamentals.[5]
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,[6]
while Buffett believes that short sellers are useful in uncovering
fraudulent accounting and other problems at companies.[7]
The
regulatory response
Regulation
SHO was the SECs first update to short selling restrictions since
1938. It established "locate" and "close-out" requirements for
broker-dealers, in an effort to curb naked short selling. Compliance
with the regulation began on January 3, 2005.[8]
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.
"Short
and distort"
A "Short and
Distort" scam involves short selling a stock while smearing a
company with false rumors to drive the stock's price down.
The term was
coined in the period immediately after the collapse of Enron,
as a parallel to pump and dump. In a pump and dump, untrue or
exaggerated promotion, creating artificial demand, is carried
out to sell stock, previously purchased cheaply, at the inflated
price. In "short and distort," a stock is sold short, to profit
from declines in share prices. Untrue or exaggerated negative
information (creating artificial selling motivation) is disseminated
to allow fraudulent profits to occur.[9]
Because they've
lost money recently on bubble stocks and accounting scandals,
investors are more receptive to believing there's more bad news
ahead. Short-and-distort tactics work best with smaller companies
whose stock prices are more volatile. Companies hit by this scam
say it's difficult to fight back, given the speed at which rumors
can be disseminated online.[9]
In 2006, the
Attorney General of Connecticut Richard Blumenthal told the SEC
that there was "mounting evidence that some traders--including
hedge funds--engage in the practice 'short and distort,' " in
comments to the SEC.[10]
In Senate testimony, he said such problems "may be the aberrant
exception, a small proportion, not the rule."[11]
References
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